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KEN LEECHChief Investment Officer

Market CommentaryFEBRUARY 2015

A value investor is charged with being very explicit in analyzing risk. What are our specific expectations for a security, sector, or strategy, and how does that differ from the market price? The bigger the difference, the larger the margin of safety. With macro strategies, valuation will depend on factors subject to forecast error. What are our expectations, how do they differ from what is reflected in the market price, and what are the risk factors that will erode our margin of safety? The greater the uncertainty in the forecast, the lower our confidence in the margin of safety.

Future uncertainty can be a subjective, elusive concept. When is there not uncertainty? If the future is unknowable, why is uncertainty any higher now than at any other time? And yet I find myself looking at the interest rate landscape with some incredulity, thinking that uncertainty has never been higher. Most of us who have been immersed in the US markets for several decades look at today’s interest rates as incomprehensibly low. But when we look at other developed countries around the world (Exhibit 1), we see 10-year maturity bond yields that in many countries are fractions of 1%. The major European periphery countries of Spain and Italy, deemed on the verge of collapse a little over three years ago, now enjoy yields substantially less than those in the US. And for a real head spinner, see Switzerland’s negative interest rate.

Negative 10-year interest rates? I have to pay to lend you money for 10 years! My confession is that despite a long time spent as a practitioner in the bond world, I really don’t “get” negative interest rates. I actually used to believe that zero was a floor for interest rates. I’m sure my grandchildren will one day ask me how I failed to comprehend that zero was pretty much a ceiling for interest rates. If negative interest rates jumpstart the economy, policymakers must soon comprehend that more negative rates will be even better. And yet if you take your money and stuff it in a mattress, doesn’t that provide a better return?

This brings us back to today’s interest rate conundrum. Rather than being low, US interest rates are actually high in comparison to the rest of the developed world. Developed market participants who sell their bonds to buy US securities pick up a meaningful yield advantage, and since the dollar has been appreciating, they get a currency boost as well. US bonds appear overpriced on domestic fundamentals, but they are a bargain based on global valuations.

Curiouser and curiouser! ~Lewis Carroll, Alice in Wonderland

Exhibit 1Closing Yields

Source: Bloomberg. As of 13 Feb 15

Country 10-Year Yields (%)

US 2.05Canada 1.68UK 1.69France 0.64Germany 0.34Netherlands 0.41Italy 1.60Spain 1.54Sweden 0.47Japan 0.41Switzerland  -0.01

Morningstar Awards 2014©. Morningstar, Inc. All Rights Reserved. Awarded to Ken Leech, Carl Eichstaedt, and Mark Lindbloom, Western Asset Core Bond and Western Asset Core Plus Bond for 2014 Fixed-Income Fund Manager of the Year, US. The funds are offered through Legg Mason Investor Services, LLC – www.leggmason.com.

2014 Fixed-Income Fund Manager of the Year

Western Asset February 20152

Market Commentary

Market participants often talk across each other when it comes to discussions of interest rates. Which interest rates are we discussing? Is it the central bank policy rate, in this case the overnight rate targeted by the Federal Reserve (Fed)? Or are we talking about long-term yields? Our practice is to approach this issue from two perspectives. The first is to evaluate the economic fundamentals and the probable path of Fed policy. The second is to focus on the fundamentals underlying the path of long-term inflation. The two are inextricably intertwined, and the analyses overlap, yet we still find some merit in looking at these issues separately.

Our view is that growth in the US will be solid but unspectacular. Our working premise of 2.5% growth is not as optimistic as the Fed’s 3% forecast, but this is not a huge difference. Either rate would be sufficient for the Fed to follow through on its intention to raise the federal funds rate above zero. We believe the Fed intends to start this process at mid-year, consistent with the guidance it has been communicating.

The change in the landscape that may cause the Fed to delay this process is a potential decline in core inflation. As my colleague John Bellows noted in his recent white paper, “Fed Outlook for 2015,” Fed of-ficials have stated that they need to be “reasonably confident” that they can attain their inflation target. The Fed has said it would look through the decline in headline inflation due to the drop in oil prices, which has always been its preference. But if, as we anticipate, core inflation is declining at mid-year, the Fed’s confidence in its forecast of ongoing 3% growth would have to be very strong before it would pursue policy tightening at that time.

The potential for error in GDP forecasting, particularly multiple quarters in the future, is very high. Actual GDP growth has consistently underperformed the Fed’s forecast over the last four years, and inflation has also remained below the Fed’s forecasts. On both counts, we are doubtful that the Fed will have sufficient confidence to tighten should core inflation meaningfully underperform its forecasts this year. Market prices also reflect expectations that the first rate rise will come later in the year. We have long felt the process would be a protracted one. When we specifically compare our view with today’s market prices, we find there is an insufficient difference to take a position.

Another perspective is the trend of long-term inflation. Over long periods of time, the story of long-term interest rates is just the story of long-term inflation. The factors governing long-term inflation are not always coincident with those governing short-term growth rates.

An example (admittedly contrived) to illustrate this point would be the 1982-1989 US experience. This was a period of exceptional growth, indeed one of the great economic booms in history. Based on a prescrip-tion that higher-than-expected growth often leads to a Fed reaction function more inclined to raise rates, a bond investor who was forewarned that growth would be exceptionally high would have been inclined to favor short positions. However, as we all know now, the winning strategy then was to stay long: ignore the strong growth, lock in 14% on Treasury bonds and never sell.

You would have looked like a veritable idiot during the tightening cycles, and you would have been heralded during recessionary easing bouts, but on average, across the business cycle, staying long the 30-year bond was the best strategy. The basis for that strategy would have been the secular trend of declining inflation. The end of the Cold War, globalization, the technology revolution, and demographics all helped contribute, but the determination of the monetary authorities to achieve lower rates of inflation was crucial.

As we look at the inflation horizon today, we see conflicting elements. The long-term trend in global inflation is still down, surprisingly revitalized late last year by the plunge in oil prices. The disinflationary forces previously mentioned still exert their influence. The buildup of debt in the developed economies

Western Asset February 20153

Market Commentary

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is a powerful headwind to economic growth prospects. But the key difference is the goal and determina-tion of the monetary authorities. As devoted to lowering inflation to their 2% goal as central bankers were, their devotion pales in comparison to that behind the policy experimentation utilized in their attempts to increase inflation to at least 2%.

Our steadfast view has been that the downward trend in US and global inflation would ultimately be ar-rested. Eventually, central bankers would get inflation back to their target, but this process would be a slow one, demanding a substantial continuation of monetary accommodation. Even we have been surprised by the renewed downshift in inflation. It clearly suggests this process will take even more time and that long-term rates will stay lower for longer.

…Which brings us back to the interest rate conundrum, but from another perspective. Our views of lower-than-expected growth, declining core inflation, and a more dovish-than-previously-expected Fed would normally be pretty bullish for government bonds. However, these views look to be already fully reflected in yields on short- and intermediate-maturity government securities. Similarly, at the long end, our view of an extended period of below 2% inflation would normally be constructive for long bonds, except that this view also looks to be fully reflected in Treasury bond yields under 2.5%. Market pricing appears to have overshot optimistic scenarios across the yield curve.

Where does this leave us? We believe there is no long-term value in current Treasury prices, but we respect the crosscurrents that underpin current yield levels. We are underweight government securities tactically, but we have not undertaken any meaningful strategic negative duration stance, feeling there are other, better areas with the potential to add value. Our decision not to undertake a decisive negative duration position despite the overvaluation of the government bond market could be ascribed to this extensive analysis. Another reason, more probable and even more powerful, is the consideration with which we began this note: too much uncertainty.