U.S. economic data over the last several weeks has been indicative of a slow-to-modest growth environment. The manufacturing sector continues to show strength and the labor market is improving. In January, payroll jobs grew by 243,000, much better than the 135,000 boost that the market was expecting. The unemployment rate dropped to 8.3% in January from 8.5% in December. After the employment report, comments from Federal Reserve Chairman Bernanke remained dovish; foreshadowing the Federal Reserve does not intend to alter its accommodative stance. Though recent economic indicators have improved, we remain cautious about the global economy, particularly in light of the ongoing turmoil in Europe and concerns about decelerating growth in China. A severe contraction in the European economy caused by its debt crisis could impair the U.S. economic recovery. Furthermore, though the overall domestic economy seems to be strengthening, the housing sector remains sluggish and consumer spending continues to be uneven.

In January, the Fed announced that it would retain the policy rate range of 0.0-0.25%. Notably, the Fed stated that it now expects the fed funds rate to remain exceptionally low through late 2014, versus its previous statement that rates would remain exceptionally low through mid-2013; otherwise, the statement was virtually unchanged from December. The Fed continues to believe that the economy is expanding moderately despite a slowing in global growth.

Use as Yield Curve Quote:

Title: TREASURY YIELDS MOSTLY LOWER IN JANUARY

Treasury yields moved modestly lower in January, with the exception of the long end of the curve which moved slightly higher.

Labor Markets
The January employment report showed that the economy added 243,000 jobs with the six-month average at 167,000 jobs. The unemployment rate fell from 8.5% to 8.3%. This report was better than analysts’ expectations with many markets participants forecasting continued positive labor market momentum into early 2012. Although the unemployment rate remains elevated, current economic data suggests the labor markets maybe entering a period of slow sustained growth.

Retail Sales
In December, Retail Sales rose 6.5% on a year-over-year basis. Consumer spending has rebounded from the depths of the recession and recent activity has been moderate; however, high unemployment continues to restrain consumer spending.

Housing Starts
Single-family housing starts rose 4.4% in December to 470,000, compared to 450,000 in November. The housing market remains under pressure, but seems to have stabilized following several years of sharp declines, and some housing data has recently surprised to the upside.

NEED CREDIT SPREADS AND ECONOMIC DATA CHARTS

The FOMC has a dual mandate: fostering maximum employment and ensuring price stability. The way the FOMC communicates its policy goals and actions plays an important role in enhancing monetary policy and reduces economic and financial uncertainty. The January changes are the most recent in the FOMC’s evolution to greater transparency in the interest of making financial markets less volatile and more reflective of relevant information for monetary policy.

Specifically, the new approach will provide information in three areas:

• FOMC members’ projections of the appropriate level of the target federal funds rate in the fourth quarter of 2012, the next few calendar years, and over the “longer run.”

It is worth noting, the FOMC does not forecast the Federal Funds rate since it actually sets the Fed Funds target. The forecasts for inflation, GDP and unemployment are dependent upon the interest rate it sets. Each committee participant is instructed to assume the path consistent with the committee’s longer-run objectives and then provide forecasts of GDP, inflation, and unemployment.

• FOMC members’ projections of the timing of the first increase in the target rate.
• A narrative describing factors underlying the assessments and qualitative information about participants’ expectations for the Fed’s balance sheet

The forecasts do not identify participants individually.

While there are benefits to greater transparency and accountability that the enhanced communication fosters, arguments may be made that providing such information might increase market volatility especially during times when forecasting is more challenging than today.

What the Fed Actually Said
Market expectations have been that the Federal Reserve would maintain its target Federal Funds (Fed Funds)¹ rate at current low levels through mid 2013. Significantly, the Fed pushed back the date for any likely increase in this interest rate by at least a year and a half, until late 2014 at the earliest. The Fed stated that rates at such levels continue to be needed to help boost an improving but still sluggish economy.

Beyond the adjusted outlook for interest rates, Wednesday’s statement closely tracked the Fed’s previous comments about economic conditions. The Federal Reserve reduced its outlook for economic growth for 2012 but expressed a slightly more optimistic view about the unemployment rate. It expects the economy to grow between 2.2 percent and 2.7 percent this year, a decrease from the November forecast of between 2.5 percent and 2.9 percent. It expects unemployment to fall as low as 8.2 percent this year, an improvement over the earlier forecast of 8.5 percent.

In implementing the new communication strategy, the Fed provided a rate forecast and a forecast of the timing along with the expectations of the 17 individual Fed policymakers.² The distribution charts clarify the consensus and range of forecasts amongst the participants. Some Fed participants forecast record-low interest rates beyond late 2014 while others see increases sooner. While the consensus is to hold rates low and the Fed stated there will be “exceptionally low rates through at least 2014” reviewing dispersion of the forecasts in the charts suggests that this does not necessarily mean 0.00-0.25%. The Fed could raise rates slightly before the end of 2014 and the rate would still be “exceptionally low.” Individual forecasts of the movement of the Federal Funds rate were revealed, with six participants anticipating interest rate hikes in 2012 or 2013, in contrast to the broader expectation for low rates through 2014.

Market Reaction
Market reaction to the new communication approach was subdued, with some concern about policy error, increased risk of inflation and its consequent effects on fixed income securities. In the future the dispersion of the participants’ Fed Funds rate and timing forecasts may heighten market volatility.

Continuing Operation Twist
The Fed sees the economy growing at a modest pace. It held off on any further bond-buying programs to try to increase growth at this point. During 2011, the Fed implemented a program of buying government bonds and mortgage-backed securities with the goal of driving down long-term rates and easing borrowing costs. In driving down interest rates, the Fed seeks to encourage people and businesses to borrow and spend, bringing down unemployment. While not announcing further bond buying, the Fed did hold out the possibility of doing so later. It said it was prepared to adjust its “holdings as appropriate to promote a stronger economic recovery in the context of price stability.”

Concluding Thoughts
The recent action to detail the interest rate projections of each of the 17 members who participate in policy meetings, without identifying them by name, advances the Federal Reserve towards more open communication. While market response to the inaugural implementation of this approach was muted, it will be interesting to gauge the market’s response in the future.

Footnotes
¹ The Federal Funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually on an overnight basis. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. The federal funds target rate is an administered rate, determined by a meeting of the members of the Federal Open Market Committee.
² Currently there are 17 participants: Five are Federal Reserve Board Governors and twelve are Federal Reserve Bank Presidents. There are two Federal Reserve Board Governor positions that are unfilled. Only five of the 12 regional Federal Reserve Bank Presidents get to vote at meetings, on a rotating basis, meaning seven people get express their views but not decide.

1. Requires Consideration of the Proper Risk Profile
The first step in selecting an appropriate benchmark is determining the proper risk profile for an entity’s portfolio. This is based on investment constraints, investment objectives, and the risk tolerances of the entity. There are fixed income benchmarks available for just about any risk profile an investor might select as appropriate. A benchmark is a composite of securities that meet certain criteria, such as duration or maturity, credit quality, and asset class for example. Effective benchmarks are:

• Unambiguous and transparent – the names and weights of securities in the benchmark are clearly defined
• Investable – an investor can purchase the securities in the benchmark
• Measurable – the benchmark’s return is calculated regularly
• Appropriate – the selected benchmark should be consistent with the style being gauged
• Reflective of current investment opinions – all market participants must be able to have current knowledge of the benchmark
• Specified in advance – the benchmark is constructed prior to the start of evaluation

The lengthy historical performance data for benchmarks provides investors valuable information on how different risk profiles perform in various interest rate scenarios. The mere process of selecting a benchmark based on the proper risk profile for a portfolio provides an investor the critical, but often missed, opportunity to examine carefully the level of risk and degree of diversification that is most appropriate for the investor.

2. Creates Disciplined Investment Process
Benchmarks are not only used for measuring and evaluating the performance of a portfolio, but also for making investment decisions, such as the mix of securities that will create the targeted risk profile in the portfolio. The benchmark an investor selects helps create discipline in the investment process by establishing a framework for choosing securities that have the proper type and level of risk for the portfolio. For that reason, once selected, benchmarks should only be changed when an investor’s constraints, objectives, or risk tolerances change. They should not be changed solely because market conditions change or because the portfolio is being managed to different risks characteristics than the benchmark.Benchmarks create discipline by:

• Providing guidance for investment decisions and security selection
• Keeping an investor focused on maintaining the targeted risk profile
• Controlling exposure to interest rate changes in the portfolio by targeting the benchmark’s duration
• Improving return and earnings expectations in various interest rate environments

3. Measures Effectiveness of Strategies
The effectiveness of an investment program, whether it is achieving its objectives, can be measured by comparing the total return of the portfolio to that of the benchmark. Total return measures total outcomes of investment decisions. It measures the percent change in the value of a portfolio over a defined past period, taking into consideration not only interest earnings, but also realized and unrealized changes in market value that occurred during the measurement period.The goal is not to significantly outperform the benchmark but to achieve a total return comparable to that of an appropriate benchmark with comparable levels of risk. Any returns that are much greater or much less than that of the benchmark should be analyzed.

4. Provides Valuable Information on Fulfilling Fiduciary Duty
Certain investors have special duties for the funds they manage. Investors of public funds, for example, have such a special responsibility for the funds they manage. They are fiduciaries subject to a relationship of trust with the beneficiaries of the funds under their care. They are legally responsible for these funds, and must act prudently and always in the best interest of the beneficiaries.The primary objectives of public sector investment portfolios are safety, liquidity and yield or return. Safety and liquidity always take precedence over the objective of yield or return. The test of a fiduciary is one of conduct. Comparing the risk characteristics and total return of the portfolio to that of the selected benchmark allows finance directors, treasurers and oversight boards to evaluate whether the portfolio’s return is commensurate with the agreed upon targeted risk profile. Total return benchmarks assist in the monitoring of fiduciary duty by:

• Providing clear strategy communication to board / others
• Managing expectations of returns (and risk)
• Performance should be close to the benchmark return
• Any variance in return will be due to variance in decisions for duration, sector weighting, credit quality, and maturity structure
• The degree of variance in the portfolio’s return will inform an oversight board on the manner in which the portfolio’s risk is being managed relative to the selected benchmark’s risk

5. Total Return Benchmarks are the Accepted Industry Standard
Total return is the agreed upon industry standard. It is universally accepted by academic literature and best practice. Uniformly applied to all portfolios, it provides full disclosure, transparent and fair representation of investment performance to allow comparison and evaluation. Yield only measures the income that can be expected from a portfolio during a given period. In preparing annual portfolio revenue projections and for budgeting purposes, yield information can be helpful. However, yield does not measure risk in the portfolio and cannot be compared against a benchmark on a risk and return basis. There is no standard definition of yield. Investors can chose between yield to maturity, yield to call, book yield, and market yield. As well, yield results can be distorted by timing decisions. For example, an investor can decide to generate more income and thereby show higher yield in one particular period by selling securities that show gains. Because of the potential for variability in yield, it provides limited information and no assessment of the risk in a portfolio and how the investor’s decisions are working out.

Only by using total return measures compared to an appropriate total return benchmark can an investor gauge the success or failure of his portfolio decisions.

Retail Sales
In September, Retail Sales rose 7.9% on a year-over-year basis. Consumer spending has rebounded from the depths of the recession and recent activity has been moderate; however, activity is still far short of the heights of the previous economic expansion as a weak job market and high energy prices restrain consumer spending.

Labor Markets
The October employment report showed that the economy added 80,000 jobs and the previous two month’s totalswere revised higher by 102,000. The unemployment rate fell to 9.0 from 9.1%. This report was an improvement; nevertheless, the employment situation in the country remains poor. Even though the economic recovery is more than two years old, the pace of recovery in the labor market has been weak, and is one of the primary reasons why the recovery has been tepid.

Housing Starts
Single-family housing starts rose 1.7% in September to 425,000, compared to 418,000 in August. The housing market remains weak but seems to have stabilized following several years of sharp declines.

Recent domestic economic data has improved slightly, helping to calm some fears that another U.S. recession might be near. The three-month moving average of non-farm payrolls is 114k, not enough to bring down the unemployment rate of 9.0%, but yet not weak enough to cause a material downdraft in economic growth. In our view, domestic economic data remains indicative of a slow growth environment. However, political turmoil related to the sovereign debt crisis in Europe has heavily influenced the day-to-day movement in global equity and bond markets and largely overshadowed any positive or negative economic news out of Asia or the United States. The sovereign crisis in Europe has spread with concerns shifting from Greece to Italy, where borrowing costs have jumped sharply. Some market participants are concerned that a severe contraction in the European economy could derail the already fragile U.S. economic recovery. We continue to believe the U.S. economy will muddle along at a slow pace, but an escalation of the crisis in Europe could alter our view.

In early November, the Fed announced it would keep its Fed funds target rate unchanged at 0%-0.25% and expects to keep the rate exceptionally low through mid-2013. The Fed will also continue to engage in “Operation Twist” by extending the average maturity of its Treasuries purchases. This program is intended to put downward pressure on longer-term interest rates. The Fed expects a modest pace of economic growth in coming quarters, but noted, “there are significant downside risks” to the current economic environment. The Fed slightly lowered its outlook for economic growth in 2012 and 2013, and now expects the economy to expand by about 2.7% in 2012, 3.3% in 2013. The next regularly scheduled FOMC meeting is December 13.