Legg Mason
Thought Leadership™
O BRAVE NEW WORLD
•
Ken Leech
Co-Chief Investment Officer
•
•
As policy has begun normalizing, so has the Treasury
yield curve
Moderate growth and low inflation could continue to contain
any meaningful rise in longer Treasury yields
We believe the Fed on perma-hold environment has passed
and expect a much flatter long end of the Treasury yield curve
This document reflects the opinions, views and analysis of Western Asset
regarding conditions in the economy and markets, which are subject to
change, and may differ from those of other professional investment managers.
MAR 2014
Past performance is no guarantee of future results.
All investments involve risk, including possible loss of principal.
This material is only for distribution in those countries and to those recipients listed.
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KEN LEECH
Market Commentary
MARCH 2014
O brave new world, That has such people in’t! ~Miranda to Prospero in “The Tempest”
Executive Summary
Bond markets have rallied strongly this year. Fears of accelerating growth combined with the Federal Reserve’s
(Fed)1 commitment to “taper2” asset purchases had led to arguably the most consensus bearish sentiment
on rates in many years. Instead, however, two months into the year, growth appears to be tracking the 2%+
level that has characterized the five years of the recovery. Inflation remains near the lows of recent years.
Optimism about global growth has also dimmed. Fears of a downshift in Chinese growth and the severe
challenges of many emerging market economies, not to mention the complete disarray in Ukraine, have
dampened expectations.
ƒƒ Fears of accelerating growth
combined with Fed commitment to “taper” asset purchases has led to a consensus
bearish sentiment on rates.
But two months into the year,
growth is tracking the 2%+
level.
Ever since the Fed indicated in November its intention to re-commit to a tapering process (which commenced
in December), the Treasury yield curve3 has flattened sharply (Exhibit 1). Over this period, five-year notes have
risen 13 basis points (bps4) while bond yields have actually fallen 33 bps. As policy has started to normalize,
so too has the yield curve. This represents the new challenge fixed-income investors are facing: we have
never before experienced the enormity of monetary policy experimentation that has ultimately expanded
the Fed’s balance sheet to $4.1 trillion, so we don’t know what the eventual withdrawal will look like.
ƒƒ As policy has begun normalizing, so has the yield curve. The
challenge fixed-income investors are facing is that we have
never before experienced this
enormity of monetary policy
experimentation, and don’t
know what the withdrawal
will look like.
Exhibit 1
Yield Change (20 November 2013 to 28 February 2014)
ƒƒ Dramatic spread widening in
the summer of 2007 signaled
impending financial system
risk. The extraordinary acceleration of the widening of
these spreads through 2008
foretold the impending crash.
Today, similar spreads are suggesting quite the opposite.
20
Basis Points
10
13
4
0
-10
-15
-20
ƒƒ In three cases following extended periods of Fed easing,
the yield spread has moved
above 100 bps. The very wide
level of this spread currently
presents an attractive opportunity.
-30
-33
-40
2 Year
5 Year
10 Year
30 Year
Source: Bloomberg. As of 28 February, 2014. Past performance is no guarantee of future results. This information is provided for
illustrative purposes only and does not reflect the performance of an actual investment.
Our view is that moderate growth and low inflation will continue to contain any meaningful rise in longer
Treasury yields, even if and as the Fed very, very slowly removes policy accommodation. Indeed, this is what
the flattening yield curve appears to be suggesting. We think this trend will continue.
The Federal Reserve Board (“Fed”) is responsible for the formulation of U.S. policies designed to promote economic growth, full employment,
stable prices, and a sustainable pattern of international trade and payments.
2
Tapering refers to the Fed’s announced approach to reduce the pace of its monthly asset purchases gradually instead of ending the purchases
all at once.
3
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
4
A basis point (bps) is one one-hundredth of one percent (1/100% or 0.01%).
1
Western Asset
2
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March 2014
Market Commentary
Fed Policy—Breezy Historical Review
Let’s review the monetary policy of the crisis and post-crisis years in order to get a sense of whether the yield
curve will look much different going forward. The minutes of the Fed’s meeting immediately after the Lehman
collapse5 were recently released. In those minutes, Ben Bernanke commented that the Fed’s (low) 2% funds
rate policy seemed to be working quite well. His perception, and that of many others at the time, was that
2% was an ultra-low policy rate that was too low relative to the Fed’s forecast of growth, but necessary (and
sufficient) to keep the crisis contained. Consider for a moment just how spectacularly different that thought
process is from today. We are no longer experiencing the financial crisis to which Bernanke and his colleagues
were obviously referring and which the 2% funds rate policy was meant to address, yet keeping rates at zero
indefinitely to help the economy is still the order of the day. (Indeed, we sometimes joke about the fact that
we have a meaningful number of young employees who have never known any other funds rate but zero!)
Consider, too, for a moment, how different this same thought process is from that period of time preceding
the crisis. The credit markets were flashing near catastrophic warnings, but the concept of “below 2%” just
wasn’t really considered. That (mis)judgment was almost instantly followed by the financial meltdown that
led to the TARP6 initiative in just days. Exhibit 2 shows the history of senior bank yield spreads versus Treasuries
in the US and the similar spreads for Europe since 2007. As spreads widen, the market’s judgment is that the
probability of default is increasing. The dramatic widening in these spreads in the summer of 2007 signaled
impending financial system risk. The extraordinary acceleration of the widening of these spreads7 through
2008 foretold the impending crash. In Europe, the financial crisis was nearly revisited in 2011 as the European
Central Bank (ECB)8 kept tightening even as bank bonds (and peripheral debt) were plummeting.
Back to the Future
Exhibit 2
Senior Bank Spreads
600
US
500
Spread (bps)
400
300
200
Euro
100
0
2007
2008
2009
2010
2011
2012
2013
2014
Source: Barclays, As of 26 February, 2014. Past performance is no guarantee of future results. This information is provided for
illustrative purposes only and does not reflect the performance of an actual investment.
The Lehman collapse refers to the bankruptcy filing by Lehman Brothers on September 15, 2008.
The Troubled Asset Relief Program (TARP) is a government program created for the establishment and management of a Treasury fund, in an
attempt to curb the financial crisis of 2007-2008.
7
A spread is the difference in yield between two different types of fixed income securities.
8
The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency.
5
6
Western Asset
3
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March 2014
Market Commentary
Today, similar spreads are suggesting quite the opposite. The enormity of the Fed’s response after Lehman,
and the continued determination to prevent another downside break by using heretofore unheard of
measures over the last five years, have together been crucial in allowing the financial system to stabilize
and finally heal. Current bank spreads are now at their lowest level since 2006. With the systemic risk threat
currently off the table, the Fed’s unwind of emergency policy has commenced. Investors accustomed to
never-ending carry and roll down now have to gauge how much they believe interest rates will rise relative
to forward rate expectations.
This makes the purchase of short and intermediate securities more treacherous. It also completely changes
the dynamic of yield curve investing. With the Fed seemingly on hold at zero rates forever, an investor was
incentivized to play for a yield curve steepener. The carry and roll down per unit of duration of an intermediate security was much better than that of longer maturities, and the downside price risk was well anchored.
This led to a massive steepening of the yield curve. But while forward expectations of the path for fed funds9
may be well defined for a number of years, the forward expectations between 10s and 30s are reasonably
opaque. Historically the spread between these two points has been narrow (Exhibit 3).
Exhibit 3
Percent per Year
2.0
1.5
1977–2014 Mean: 35 bps
1977–2014 Median: 26 bps
1.0
1977–2007 Mean: 22 bps
1977–2007 Median: 19 bps
Treasury Yields Spreads: 30s Versus 10s
0.5
0.0
-0.5
-1.0
1.0
1980
1985
1990
1995
2000
2005
2010
Yields on Composite Index of Long T-Bonds10 Over Yields on 10-Year T-Notes
Percent per Year
0.5
0.0
-0.5
1953–2014 Mean: 24 bps
1953–2014 Median: 8 bps
-1.0
1977–2014 Mean: 22 bps
1977–2014 Median: 32 bps
-1.5
1960
1970
1980
1990
2000
2010
Sources: Federal Reserve Board and US Treasury. As of 21 February, 2014. Past performance is no guarantee of future results.
Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information
is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Since the bond auction process of 1977 to the present, this yield spread has averaged 35 bps. In three cases
following extended periods of Fed easing, this spread has moved above 100 bps. Subsequently the spread
has contracted sharply. Over a much longer period of time (1953-2014),11 the persistent flatness for this relaThe federal funds rate (fed funds, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing
U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need
overnight loans.
10
The Composite Index of Long T-Bonds reflects the unweighted average of bid yields on all outstanding fixed-coupon bonds neither due nor
callable in less than 10 years.
11
Focuses on a slightly different spread metric with slightly different current value.
9
Western Asset
4
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March 2014
Market Commentary
tionship is evidenced by the average spread of 24 bps. The very wide level of this spread currently presents
an attractive opportunity, in our view.
An overweight position to the long end of the yield curve benefits not only as a standalone position, but we
believe also has powerful portfolio benefits. As we illustrated in a previous paper,12 the benefits of long bonds
as a portfolio diversifier to credit and other spread product positions has been historically very effective. Long
bonds have very substantial positive convexity13 attributes. They are crucially important in the foundation of
long-dated liability matching portfolios.
A much lower growth environment has resulted in bull market curve flattening14 in each episode over the last
five years. Periods of accelerating growth have led to bear market curve flattening15 like last summer. Certainly,
the scenario of an overly accommodative Fed that fails to correct even after inflation accelerates is hazardous.
A more relevant risk to our flattener scenario would be a continuation of the not-too-hot, not-too-cold, Fed
on perma-hold environment of the last nearly five years. We think that time has passed. We look for a much
flatter long end of the Treasury yield curve.
History may not prove to be a precursor for future markets. The Fed’s inflation fighting regime clearly kept
the yield curve in a flatter position than one in which the Fed may tolerate a higher inflation rate. Perhaps
the Fed will not only succeed in getting higher inflation, but will simultaneously persist in keeping short
rates artificially low, promoting an ever steeper yield curve. Such fears were certainly voiced as recently as a
year ago. But the distance from the crisis, the amelioration of systemic risk, and most importantly, the Fed’s
tapering decision in a low inflation environment suggest that a more normal outcome lay in store.
Investment risks
All investments involve risk, including loss of principal. Past performance is no guarantee of future results.
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of
actual future events or performance, or a guarantee of future results, or investment advice.
Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible
loss of principal. As interest rates rise, the value of fixed income securities falls.
Foreign securities are subject to the additional risks of fluctuations in foreign exchange rates, changes in
political and economic conditions, foreign taxation, and differences in auditing and financial standards. These
risks are magnified in the case of investment in emerging markets.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the
securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies
and instrumentalities and related investments may or may not be backed by the full faith and credit of the
U.S. government. Even when the U.S. government guarantees principal and interest payments on securities,
this guarantee does not apply to losses resulting from declines in the market value of these securities.
Unless otherwise noted the “$” (dollar sign) represents U.S. dollars.
Ken Leech, Market Commentary, April 2013.
Convexity is a measure of the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a
bond changes as the interest rate changes. Convexity is used as a risk-management tool, and helps to measure and manage the amount of
market risk to which a portfolio of bonds is exposed. As convexity increases, the systemic risk to which the portfolio is exposed increases.
As convexity decreases, the exposure to market interest rates decreases and the bond portfolio can be considered hedged. In general, the
higher the coupon rate, the lower the convexity (or market risk) of a bond. This is because market rates would have to increase greatly to
surpass the coupon on the bond, meaning there is less risk to the investor.
14
In a bull market curve flattening episode, long term bond yields decrease while short term bond yields increase.
15
In a bear market curve flattening episode, short term bond yields rise faster than long-term bond yields.
12
13
Western Asset
5
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March 2014
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