The economy and financial markets continued to recover as more favorable economic data concerning employment, consumer spending, and manufacturing was released during the last three months. Historically, after a recession as severe as the one we had, the economy usually has a quick rebound. However, this recovery is expected to be slower than normal because of a struggling housing market, deleveraging, and an injured financial system.
After both of the Federal Open Market Committee meetings in the fourth quarter the Federal Reserve (the “Fed”) kept the federal funds rate near zero. Comments at its last meeting suggest that the Fed seems inclined to keep the fed funds rate near zero as long as inflation expectations are constrained and economic growth is moderate.
Interest rates moved higher in the fourth quarter as more signs of the economic recovery became apparent. The Fed’s announcement that by the end of the first quarter it plans to cease the purchase of agency mortgage-backed securities added upward pressure on rates. Yields for 2 to 5 year treasuries increased 20 to 35 basis points.
The Short-Term Government Fund’s return for the fourth quarter exceeded the Citigroup 1-5 Year Treasury/Government Sponsored Index. The Fund’s underweight in treasuries relative to the benchmark contributed positively to performance. While the strategic overweight of mortgage-backed securities (MBS) helped the Fund outperform on average, some security selection within the MBS sector hindered performance.
For the coming quarter we expect agencies and MBS should continue to outperform treasuries, but to a lesser extent than realized last year. Performance may be hindered by the possibility of rising interest rates.
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