Q3 Bond Market Meltdown: Why and What's Next?

As the Federal Reserve signals it will keep interest rates higher for longer, the market appears to be reflecting the uncertainty about the path of policy going forward.

The third quarter was very tough for bond investors as yields surged and prices—which move inversely to yields—dropped. The selloff was led by intermediate- and long-term Treasury bonds, whose yields rose to the highest levels in more than a decade. Only very short-duration fixed income investments managed to post gains.

The rout was somewhat surprising, as it came against a backdrop of the Federal Reserve's decision to skip a rate hike at its September policymaking meeting, easing inflation pressures, and concerns about slowing global growth—especially in China and Germany, two of the world's largest economies. These are generally factors that are positive for bond prices.

Third-quarter returns by fixed income asset class

"Higher for longer" raises the term premium

While many explanations have been offered—a resilient economy, increasing budget deficits to fund, inflation fears, and lack of foreign demand among them—the evidence points to a different reason.