Western Asset's Duration Positioning

Western Asset's Duration Positioning

Key reasons why Western Asset maintains its long duration position


Western Asset has received numerous questions on the “long duration” positioning of its strategies. How can Western maintain a long duration position during a Fed tightening cycle and while market pundits are calling for higher interest rates? The following information is intended to serve as reasons why Western maintains this “long duration” position.

Key reasons why Western Asset maintains its long duration position

Western believes GDP growth will be in the 2.5% to 3.0% range: Unlike many market pundits that expect higher U.S. growth in the second half of the year, we believe GDP will be in the 2.5%–3.0% range during 2H18 (notwithstanding the fact that the recently released GDP print was 4.1%). Also, the Fed’s own expectation for growth is 2.75%–3.0% in 2018, 2.25%–2.75% in 2019, and 1.75%–2.0% in 2020.

Western does not believe that inflation is going to surge this late in the cycle: Nominal U.S. GDP has averaged 4% over the last 20 years, so we push back on the notion that it’s about to accelerate this late in the cycle when the Fed is raising interest rates and reducing its balance sheet, albeit at a very gradual pace. Eight years into the current expansion, the economy has been hit with meaningful fiscal thrust in the form of tax cuts and greater government spending but the inflation rate is barely hitting the Fed’s target of 2%. The process of inflation normalization, and hence interest-rate normalization, is expected to be very slow to develop. The markets, however, have shifted quickly and sharply to higher inflation expectations. Western is not in this camp.

Long-term secular challenges remain: The existing “full employment” conditions have led many to extrapolate an improvement in the inflation data to affirm that interest rates have to move up meaningfully. Western’s view is that the short- term pickup in cyclical inflation doesn’t remove the long-term secular challenges that exist (e.g., demographic challenges, globalization, automation and higher debt loads).

Western’s long duration position is intended as a hedge against adverse events: Western believes that the low-inflation world is not going to change quickly. Portfolios need buffers against adverse events, and Treasury securities remain the best diversifying hedge. If there are any meaningful market disruptions, long Treasury bond gains should help provide a cushion. 

Western’s view is that the Fed will continue to be cautious in the face of a very uncertain outlook: For the reasons discussed above Western does not think that the Fed is on a pre-determined path and they will remain cautious. In Western’s view, current forward rates are close to its forecast for the terminal fed funds rate; therefore, Western sees opportunities to have duration on the front end of the yield curve at this time.

The Fed is in a tightening cycle — Doesn’t that mean that rates are heading higher?

The answer to that question is “yes” as it relates to the front end and “no” as it relates to the back end of the curve. While the Fed controls the front-end, the back end of the curve is still heavily influenced by (1) inflation expectations and (2) growth outlook. When examining the last three tightening cycles, the back end of the curve has done really well (see Exhibit 1 for total return data). As outlined above, Western anticipates that inflation will rise to the 2% target. The Fed is indicating a terminal rate of 3.0% while the forward markets are already there. On the growth front, we anticipate GDP will print in the 2.5%–3.0% range. In the three most recent tightening cycles, the back end of the Treasury curve was unchanged to lower. The current cycle, that started December 2015, has seen long Treasury yields increase only marginally (see Exhibit 2). In both the 2004–2006 and 1999–2000 tightening cycles, long Treasury yields finished lower after the tightening cycle ended (see Exhibits 3 and 4). Against Western’s inflation and growth outlooks, are there any reasons to believe that this tightening cycle will end differently? Western does not believe so.

Separately, the higher interest rate calls renewed attention to this asset class.

Western believes fixed-income is all about coupon and income.

 

Exhibit 1

 

Source: Bloomberg Barclays.

 

Exhibit 2: December 2015 – Current

 

Source: US Treasury.

 

Exhibit 3: June 2004 – August 2006

Source: US Treasury.

 

Exhibit 4: July 1999 – July 2000

Source: US Treasury.


Duration measures the sensitivity of price (the value of principal) of a fixed income investment to a change in interest rates. The higher the duration number, the more sensitive a fixed income investment will be to interest rate changes.

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