Over the last several years, the central premise of Western Asset's strategy has been a cautious optimism that both global economic imbalances and US debt burdens were ultimately manageable.

We started with a near consensus forecast of 3.5+% growth, rising inflation (albeit from very low levels), and Fed tightening beginning in summer. We felt that with the long era of disinflation behind us, stimulative fiscal and monetary policy had gained traction; that the economic recovery was broadening and looked to be self-sustaining; and that Fed policy would follow the explicit course of a gradual removal of accommodation, with no policy restraint on the visible horizon.

Over the first half of this year, however, the markets relentlessly disagreed, producing a series of violent market swings. Early in the year, we were judged too optimistic. In the spring, we were challenged as too pessimistic. Throughout, the doomsayers painted scenarios of very alarming yet eminently plausible outcomes, to which market pricing swiftly ascribed high probabilities. It is only now that our forecast has been embraced, and given the speed of recent market fluctuations, this missive needed to be penned quickly.

That the bond market performance was a story in two halves can be seen by the roughly equal but opposite returns of the two quarters. (Exhibit I). The first quarter brought tales of a jobless recovery and expectations that the Fed would be on hold indefinitely. The second quarter following, much stronger employment data and fears of swift and potentially severe Fed tightening, brought a massive reversal. The severity of the market's collapse in this quarter led to a -2.4% return for the Lehman Aggregate Index, the worst in ten years. By mid-May, expectations for Fed tightening had ratcheted up 125 basis points for this year-end and 275 basis points by next year-end. And that was despite the Fed's vocal insistence that the pace of Fed tightening would be "measured."

Figure 1 Lehman Aggregate Index

The reason we stepped back from our bearish interest rate stance was that the market presented the pessimistic Fed tightening scenario as a mean expectation, — not more reasonably — a worst case. So even though we continued to believe the inflation impulse was higher, our premise of moderating growth against a backdrop of very favourable prices led us to take long positions in short-maturity instruments. Getting long the front end of the yield-curve just as the Fed begins a tightening campaign may be believed by some (many) as akin to jumping in front of a freight train. But the subsequent 50-basis point rally, based on a mild moderation in the economic data, lends credence to the exceptional opportunity the market was presenting.

In contrast to the excitement from interest rates, the range of returns on the sector front has been the most limited in years. (Figure 2). The range in investment-grade sectors has been particularly narrow, with mortgages performing best. The challenge we faced at the beginning of the year --- (long dash) favourable fundamentals being nearly fully valued--- (long dash) has persisted. Corporates performed in line with Treasuries despite the better economic performance. Such tight dispersion made inter-sector differential performance challenging. On the broader front, in high yield, lower default rates benefited performance. The energy and pipeline sector performed particularly well given the boost in oil prices. Emerging markets struggled a bit, as high early year valuations and Fed-tightening fears overlaid specific country concerns.

Figure 2 Lehman Index: Sector Returns Year to Date Ending 6/30/04

Our challenge is that valuations have outpaced our premise of cautious optimism. Volatility has declined sharply in both fixed-income and equity markets. The complacency with regard to the economic outlook is surprising. Risks, while manageable, are not insignificant. The withdrawal of monetary stimulus has to be managed adroitly. With the moderation in economic growth, the consumer's ability to handle a sharp increase in rates is questionable. On the other hand, recent developments on inflation are unsettling. While the Fed has showed a clear willingness to ascribe the recent increase to "transitory" factors, the market might not be so patient. We remain optimistic, but insist that we be paid fairly for the risks involved.

We are particularly cautious on mortgages. (Exhibit 3). The yield spread to Treasury bonds as measured on an absolute or an OAS (option adjusted spread) basis has reached its tightest levels in years. As all homebuyers know, falling rates are terrific for borrowers. Every downtick presents another opportunity to refinance, but if rates go up, it's someone else's problem. That someone is your bond manager. Sharp changes in interest rates shorten portfolio maturity in a rally or lengthen maturities in a decline. This "negative convexity" is the risk one bears in exchange for the yield advantage over Treasury bonds. Market complacency has led to an insufficient yield premium to compensate for the risk of alternative economic scenarios. For this reason, we have moved to an underweight mortgage position.

Exhibit 3 Mortgage-Backed vs. Treasury Analysis

Another concern on mortgages is the underlying prepayment estimates used in formulating duration. The buoyancy of the housing market and the extraordinary opportunities to refinance have led to much faster housing turnover and prepayments than several years ago. If the rapid rise in housing prices should moderate, let alone reverse, a return to the slower prepayment speeds may be in the offing. If this were to occur, current valuations based on estimates of short/intermediate durations might have to be revised, with adverse consequences.

The tightening of high-quality yield spreads as market complacency increases continues to suggest the need for further caution. We reduced our overweight in credit earlier this year, and are under weighting mortgages currently. We have modest overweights in the plus sectors for clients who allow them. Our starting forecast is suggestive of a benign environment whereby the higher yields would produce outperformance. But we need to be respectful of the possibility of more adverse outcomes. There is precious little room for error in market pricing, whereas there is plenty of room for error in the economy and policymaking. Playing it a little closer to the vest will have to suffice until yields and yield spreads return to more favourable levels.