UNLESS AND UNTIL FEB Fed update. Legg Mason Thought Leadership

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1 Legg Mason Thought Leadership Fed update UNLESS AND UNTIL John Bellows, PhD Portfolio Manager/Research Analyst Simply staying out of recession is unlikely to be sufficient to get the Fed to hike again in Instead, we expect the Fed to remain on hold unless and until there is a material improvement in credit markets and, equally important, a return to more normal levels of inflation expectations. It will be crucial to watch how inflation expectations evolve, as this could be the piece of the puzzle that holds the Fed back from hiking again. 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. 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. Please refer to the disclosure information on the final page. FEB 2016 IN THE U.S. INVESTMENT PRODUCTS: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 JOHN L. BELLOWS, PhD Portfolio Manager / Research Analyst POLICY MATTERS Executive Summary Simply staying out of recession is unlikely to be sufficient to get the Fed to hike again in Instead, we expect the Fed to remain on hold unless and until there is a material improvement in credit markets and, equally important, a return to more normal levels of inflation expectations. It will be crucial to watch how inflation expectations evolve, as this could be the piece of the puzzle that holds the Fed back from hiking again. John L. Bellows, PhD Western Asset Management Company Portfolio Manager / Research Analyst, 2012 U.S. Department of the Treasury Acting Assistant Secretary for Economic Policy; Deputy Assistant Secretary for Microeconomic Analysis; Senior Advisor in the Office of Economic Policy, University of California, Berkeley, PhD Economics Dartmouth College, BA Economics, Magna Cum Laude The first 2 months of the year have not gone the way the Federal Reserve (Fed) 1 hoped they would. Financial conditions have tightened: U.S. equities have fallen by 6% and corporate bonds have significantly underperformed Treasuries of similar duration 2 (investment-grade 3 bonds by 2.75% and high-yield 4 bonds by 5.5%). On top of tighter financial conditions, U.S. economic data appear to have slowed somewhat: real GDP 5 expanded by less than 1% in 4Q15, monthly auto sales have slipped after posting an all-time high last November and the U.S. manufacturing sector continues to be under pressure. In response to this litany of negative developments, investors have sharply revised their expectations for the Fed s path of rate hikes. At the beginning of the year, markets were priced for at least two more hikes in 2016 and investors thought there was a 90% chance that the Fed would hike at least once. A lot has changed since then. At one point this month, the options market implied a less than 10% probability that there would be any additional hikes this year and some investors have even started positioning for negative rates. Although pricing has since recovered on February 22 the options market implied a close to even chance of at least one more hike skepticism about future Fed hikes remains the dominant theme. Exhibit 1 Probability of at Least One More Hike in 2016 Percent Dec 15 Jan 16 Feb 16 Mar 16 Source: Bloomberg. As of February 22, Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance. Fed Chair Janet Yellen is fond of saying monetary policy is not on a preset course. We agree, and clearly so does the market, as evidenced by the responsiveness of the front end of the U.S. yield curve 6 to recent developments. In the context of such volatile conditions, providing estimates of the number of hikes this year (zero, one, etc.) is not particularly useful in terms of managing portfolios. Instead, we think it is more instructive to focus on the conditions under which the Fed will hike again. The remainder of this note discusses how we think about those conditions. Western Asset 2

3 Unless and Until We expect the Fed to remain on hold unless and until there is a material improvement in credit markets and, equally important, a return to more normal levels of inflation expectations. It should go without saying that the Fed also needs to remain confident that the U.S. economy will stay out of recession. The positive data available for January, notably including continued job growth and an improvement in retail sales, should help overcome any doubts raised by disappointing 4Q15 data. Credit markets need to clear. The Fed will not tighten if credit conditions are deteriorating. To do so would risk harming both investor and consumer sentiment, and would send an unmistakably hawkish signal. The Fed has no need or desire to be so hawkish. 7 The Fed s decision to stay on hold last September is a good example of its attentiveness to credit conditions. In explaining the decision to keep the funds rate at zero in September, the Federal Open Market Committee (FOMC) 8 statement specifically mentioned concerns about financial market volatility and international developments. Inflation expectations need to rise. The recent market volatility has led to a further decline in inflation expectations. This is a first order concern for the Fed. As Yellen said recently, the Committee s confidence in the inflation outlook depends importantly on the degree to which longer-run inflation expectations remain well anchored. While it s difficult to say exactly what it would take to force the Fed to admit inflation expectations are not well anchored, the extraordinarily low level of inflation implied in the Treasury Inflation Protected Securities (TIPS) 9 market, combined with all-time low prints in surveys about expectations, is likely making the Fed quite uncomfortable. This is yet another reason not to hike in the current environment. U.S. economic data need to be stable. There is certainly no reason for the Fed to hike if it appears that the U.S. is headed for a recession. The very few times in the past when the Fed has tightened into a recessionary environment have been when it was forced to do so by the inflation side of its mandate (e.g. as Chairman Paul Volcker did in the early 1980s). There has also been some recent discussion of the merits of tightening to prevent a build-up of financial stability risks, but there does not appear to be a consensus within the FOMC on this question. Regardless, with inflation well below mandate-consistent levels and with asset prices falling (not rising), neither consideration would suggest a reason to hike if the U.S. were headed into recession. At this point, it seems very unlikely for all three conditions to be met by the March 2016 meeting. Looking past March, however, it is not hard to see two out of three conditions being met in rather short order. U.S. economic data have proven more stable than not, and a few more-of-the-same data prints could provide the needed confidence to policymakers that the U.S. economy will weather the volatile start to the year. The second condition that could be satisfied very quickly is an improvement in credit markets: just as prices have been volatile on the way down, so too can prices be volatile on the way back up. Remember how fast credit markets stabilized after a volatile August and September 2015? The third remaining condition an increase in inflation expectations seems potentially more problematic. Absent a compelling inflationary impulse, it s not clear that stability in the economic outlook will be sufficient to restore inflation expectations. It is entirely possible that inflation expectations will languish at these worrisome levels, even as other parts of the outlook brighten. Are Inflation Expectations Well Anchored? Inflation expectations matter because they are an important driver of actual inflation. That is because inflation is, to some extent, a self-fulfilling prophecy: if price-setters expect prices to rise in the future, then they will raise prices in anticipation, thereby bringing about actual inflation. Of course if price-setters don t expect future inflation, then they will have no reason to raise prices, and prices will remain low or even decline. New York Fed President William Dudley recently underscored the centrality of inflation expectations: With respect to the risks to the inflation outlook, the most concerning is the possibility that inflation expectations become unanchored to the downside. Western Asset 3

4 The recent developments in inflation expectations have been negative. The Fed monitors two different sets of inflation expectations: market-based measures and survey measures. The most common market-based measure is the difference in yield between nominal 10 Treasuries and TIPS 11. This is commonly referred to as the TIPS breakeven rate of inflation, as it corresponds to the rate of inflation needed to make the return on TIPS equal to the return on nominal Treasuries. The Fed monitors TIPS breakevens in the 5-year to 10-year part of the yield curve known as the 5-year 5-year in order to minimize the impact of transitory factors. TIPS breakevens have been falling since mid-2014 and the decline accelerated sharply in the beginning of this year. The current level of TIPS breakevens is near its all-time low and is 75 basis points (bps) 12 below what the Fed would likely consider mandate-consistent levels 13. Even though the TIPS market can be affected by risk and liquidity premiums, just like any other financial market, the pessimistic signal from breakevens is increasingly hard to ignore. Exhibit 2 Inflation Expectations: Market-Based Measures TIPS 5-Year 5-Year Breakeven 3.0 Percent Source: Bloomberg, New York Federal Reserve. As of February 22, 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. Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance. For the past year or so, the Fed has looked past the market-based measures because survey measures have been more reassuring. This may be changing. The Fed relies on two different surveys to assess inflation expectations. The better known of the two is the University of Michigan survey, which dates back to the mid-1970s and asks consumers about expected changes in prices over the next 5 years. The second survey is conducted by the New York Fed, and while it was only started a few years ago, it has the benefit of a larger sample size and a better survey design. The New York Fed survey asks respondents about expected inflation over the next 3 years. The differences in the two surveys appear to be unimportant in the current environment, as both surveys are sending the same signal: inflation expectations are declining. The New York Fed survey for 3-year ahead inflation expectations has fallen to 2.4%, after being at 3% as recently as mid The preliminary print of University of Michigan Survey for February was 2.4%, which was the lowest print from that survey on record. It is certainly possible for these survey measures to increase in the future, but the signal right now is unambiguous and could hardly be characterized as reassuring. Western Asset 4

5 Exhibit 3 Inflation Expectations: Survey Measures Percent New York Fed, 3-Year Ahead University of Michigan, 5-Year Ahead Source: Bloomberg, New York Federal Reserve. As of February 22, 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. Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance. Most concerning, it s not entirely clear what would cause inflation expectations to rise. While it s true that marketbased measures have tended to fall on days when oil is weaker or when the dollar is stronger, the implication of that correlation is unclear. Does that mean oil needs to rise or the dollar needs to fall in order for inflation expectations to increase? With regard to survey measures, it s striking how few examples of increasing inflation expectations are present in the available data. The University of Michigan series saw increases only in 2008 and 2011, during periods when gasoline prices were rising sharply, and both times the increases were reversed 1 or 2 months later. The New York Fed series is too short to have any periods of meaningful increases in inflation expectations, and anyway the trend throughout the survey period has been decidedly down. Finally, while monetary policy has a clear theoretic role in determining expectations, in practice the impact has been rather limited. Recently the European Central Bank (ECB) and Bank of Japan (BoJ) have aggressively eased monetary policy with the stated intent of getting inflation expectations higher. They have had at best partial success, as inflation expectations in Europe remain quite low and inflation expectations actually moved lower after BoJ s recent announcement. Where Does the Fed Go from Here? After a very tumultuous start to the year, it s appropriate to step back and assess the extent of the damage. The Fed s outlook for four hikes this year is one clear casualty. As we expect will become apparent at the March meeting, the Fed s outlook has been disrupted and it is now unlikely it will proceed with the four hikes it had initially envisioned. On the other hand, we are optimistic that the U.S. economy and credit markets will survive the volatility, supported by stable fundamentals and now attractive pricing. One open question in all this is the stability of inflation expectations. Inflation expectations have fallen by a meaningful amount recently and the prospects for a rebound are anything but certain. To the extent that inflation expectations remain at these worrisome levels, we expect the Fed will remain on hold, even if the U.S. economy remains on track and credit markets recoup some of their recent loses. Of course, the Fed won t sit idly and let inflation expectations continue to decline. A first step to nudge inflation expectations would be for Fed speakers to reiterate their commitment to getting inflation higher. This is standard in most Fed speeches, but there is lots of room for a change in emphasis. Another relatively straightforward step Western Asset 5

6 would be for the FOMC statement to shift its focus from actual and expected inflation to focusing solely on actual inflation. While this may seem like a marginal change, it would be a valuable signal to the market and could provide some support to inflation expectations. Such a change has had advocates within the FOMC for some time and recently a few more FOMC members have indicated their potential support. In any case, it will be crucial to watch how inflation expectations evolve, as this could be the piece of the puzzle that holds the Fed back from hiking again. Investment risks High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues. 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. U.S. Treasury Inflation Protected Securities ( TIPS ) are bonds that receive a fixed, stated rate of return, but they also increase their principal by the changes in the CPI-U (the non-seasonally adjusted U.S. city average of the all-item consumer price index for all urban consumers, published by the Bureau of Labor Statistics). TIPS, like most fixed income instruments with long maturities, are subject to price risk. Derivatives, such as options and futures, can be illiquid, may disproportionately increase losses and have a potentially large impact on Fund performance. Western Asset 6

7 Endnotes 1 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 Duration is a measure of the price sensitivity of a fixed-income security to an interest rate change. It is calculated as the weighted average of the present values for all cash flows, and is measured in years. 3 Investment-grade bonds are those rated Aaa, Aa, A and Baa by Moody s Investors Service and AAA, AA, A and BBB by Standard & Poor s Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality. 4 High yield, or below-investment grade bonds are those with a credit quality rating of BB or below. 5 Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time. Real gross domestic product (GDP) is a nation's total output of goods and services in constant dollar, or inflation-adjusted terms. 6 The yield curve shows the relationship between yields and maturity dates for a similar class of bonds. 7 Hawkish refers to a policymaker or advisor who is generally in favour of relatively high interest rates in order to keep inflation in check. 8 The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments. 9 U.S. Treasury Inflation Protected Securities ( TIPS ) are bonds that receive a fixed, stated rate of return, But they also increase their principal by the changes in the CPI-U (the non-seasonally adjusted U.S. city average of the all-item consumer price index for all urban consumers, published by the Bureau of Labor Statistics). TIPS, like most fixed income instruments with long maturities, are subject to price risk. 10 The nominal yield is the amount of income earned from a fixed-income security divided by the security's par value, expressed as a percentage. Real yields are calculated by adjusting stated yields to compensate for inflation expectations over the time period during which the yields are expected to be paid. 11 The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index (CPI). When a TIPS matures, the owner is paid the adjusted principal or the original principal, whichever is greater. 12 A basis point (bps) is one one-hundredth of one percent (1/100% or 0.01%). 13 The Fed targets 2% inflation, as measured by the Personal Consumption Expenditure (PCE) deflator. PCE inflation tends to run about 25 bps below CPI inflation. Should the historical relationship between PCE and CPI inflation hold, a mandate-consistent level of CPI inflation would be 2.25%, or 75 bps above the current level of TIPS 5-year 5-year breakevens (1.5%). Western Asset 7

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