Q2 Bond Market Outlook for ETF Investors
With tariff uncertainty fueling market volatility, our Bond Market Outlook looks at how investors can build resilient bond portfolios.
Building Resilient Bond Portfolios
Monetary policy tends to drive bond market trends. And 2025 began typically enough, with investors debating when the Federal Reserve (Fed) might make its first rate cut and how many there would be for the year.
But then President Trump’s higher-than-expected Liberation Day tariffs disrupted norms and sunk stocks. After a bond market sell-off, the administration paused the tariffs a day after they went into effect. All this trade and market chaos has resulted in forecasts for lower global growth and higher inflation and exacerbated the uncertainty over rate cuts.
Today, bond market stability seems anachronistic. Some investors looking for shelter have increased their allocation to ultra-short bonds, which can help reduce overall portfolio risk and improve liquidity. And as uncertainty builds, rather than build portfolios primarily around potential rate cuts, it will be important for investors to focus on ways to further enhance their bond portfolio’s diversification and resiliency with:
- Active core ETFs where managers have wider remits to navigate an evolving policy landscape and seek to insulate the largest part of your bond portfolio from macro-led volatility
- Inflation-linked bonds to mitigate the impact of rising inflation and falling growth
- Multi-sector credit exposures that offer enhanced income generation as well as a positive growth bias to help position opportunistically for any reprieve — in a more resilient manner than equities
Volatility and Downside Revisions Continue
A Bloomberg survey following Liberation Day’s tariff announcements found 93% of economists were lowering their GDP forecast, 87% saw inflation rising, and 76% acknowledged increased uncertainty for businesses and consumers.1
Of course, falling growth and rising inflation expectation trends were in place before April 2. At its March meeting, the Fed downgraded GDP estimates, raised unemployment rate forecasts, and increased expected inflation figures (Figure 1).
Weakness from the consumer and uncertainty from corporations also were already in place. In the most recent reading, consumer sentiment tumbled to a two-year low, while consumer inflation expectations jumped to a 32-year high.2 At the same time, the University of Michigan Consumer Sentiment Index has revealed concerns over the labor market. Job separation readings reached their worst since 2020, personal spending expectations dropped by the most since 2021, and the outlook for personal finances hit a record low.3
The downbeat consumer coincided with US factory activity contracting for the first time this year. The Institute of Supply Management’s Manufacturing PMI has declined to a reading of 49.4 Readings below 50 indicate a contraction. Consistent with other inflation trends, the group’s price measure increased to its highest since June 2022. And over the past two months, the gauge increased 14.5 points, the most over comparable periods in the last four years.5 All this occurred before Liberation Day tariffs.
Falling growth and rising inflation expectations also meant expectations for Fed rate cuts were volatile pre-tariffs. In fact, over the past six months, the number of cuts expected by the June 2025 meeting has gone from four cuts, to no cuts, to one-and-half cuts. Now four cuts are expected for all of 2025. In February the forecast was for just two.
Since the start of the year, day-over-day percentage change in expectations became more severe and that’s unlikely to abate any time soon (Figure 2).
Seeking Resiliency Amid Uncertainty
Falling growth, rising inflation, and policy uncertainty is the path ahead for bond markets. Building a portfolio’s resilience to all three may help investors weather this new era of mercantilism.
While the temptation may be to move to cash, if the Fed cuts rates as expected, the return on cash is likely to fall. Instead, seek to increase portfolio resiliency with:
- Exposures that often react positively to falling growth and rising inflation. If the consensus surrounding lower rates for both short- and long-term rates is correct, having some duration in the portfolio above that of cash has potential to add to total returns. But simply lengthening duration in indexed core Aggregate bonds creates a portfolio that inherits the traits of those passive strategies, the antithesis of seeking resiliency.
- Active strategies that target absolute and relative value opportunities across traditional- and non-traditional sectors. Active strategies can also balance a portfolio’s duration risk throughout the curve — an especially valuable trait given the two sigma move we saw rate markets endure in April.6 This added to an environment where bond volatility has been above the long-term median for some time (Figure 3).
- Be less defensive in some portions of the portfolio. A growth-biased credit allocation can help enhance income potential amid a decline in rates while improving economic diversification if growth isn’t as severely impacted as economists and policymakers believe. While equities provide that growth bias to portfolios, a credit exposure can extend that growth bias to different sources of return/reactions to economic trends.
Implementation Ideas for Q2
Beyond an allocation to ultra-short government bonds with SPDR Bloomberg 1-3 Month T-Bill ETF (BIL) to help navigate the wide range of outcomes of this trade war, investors seeking to enhance their bond portfolio’s diversification and resiliency should consider:
Inflation-linked Bonds: Treasury inflation-linked bonds (IL bonds) have two central components: duration because they are bonds and an inflation calculation that links their payments to the rise or fall of inflation. That means they have a positive bias to falling growth — as the safety of bonds is sought in periods of economic malaise — as well as rising inflation given the inflation adjustments.
Fiscal and monetary global trends suggest a high probability of falling growth and rising inflation — or rather stagflation.
Owning IL bonds may help reduce the drag on broader portfolios, both in-and-outside-of-the US, given the global nature and impact of evolving trade war risks/tariffs.
Implementation Ideas
Core-plus active strategies: Active strategies have the flexibility to manage rate risks while pursuing opportunities in a broader universe. And that may be the most beneficial approach in the core — especially given the volatility of core Agg bonds (Figure 3).
Compared to indexed core exposures, active strategies have the potential to lower or extend duration relative to the benchmark and implement curve steepener or flattener trades to seek alpha. That flexibility’s attractive if those consensus rate forecasts turn out to be different than expected or take a non-linear path during the year as they often do.
Combining traditional (e.g., investment-grade corporates and US Treasurys) and non-traditional bond sectors (e.g., CLOs and securitized credits) can add income and diversification benefits, supporting the tactical positioning along the yield and credit curve that seeks relative value mispricings and alpha opportunities.
Implementation Idea
Multi-sector credit strategies: Growth-biased markets fell following the April 2 tariff announcement. Equities posted their worst two-day loss since the COVID-19 pandemic and high yield bonds fell by 3% and are now down on the year.7
This reflects a re-rating of growth expectations. And spreads, as a result, have widened out above 10-year averages.8 Whether or not there is more re-rating to come, the bar has been lowered.
Multi-sector credit strategies are a lower beta exposure than equities (high yield bonds have a 0.46 beta, senior loans a 0.27 beta, and investment-grade corporate bonds a 0.23 beta)9 to position toward any growth upside. Or a relaxation of tariffs, like we saw with the 90-day pause and how “risk on” growth biased markets reacted to that news.
Overall, given IL bonds and active core strategies can defend against falling growth and rising inflation, growth-biased credit could help diversify portfolios in a time of rampant uncertainty.