Market Sector Update
- The U.S. Treasury market was fairly volatile in the quarter, based on uncertainty about whether the U.S. Federal Reserve (Fed) would raise rates. The Fed did raise short-term rates in December. The yield curve shifted higher and flattened slightly during the quarter and the spread between the two-year and 10-year Treasuries tightened 19 basis points (bps). The 10-year Treasury ended the year yielding 2.27%, up 23 bps from the third quarter.
- The U.S. Federal Reserve (Fed) decided the U.S. economy was ready for higher interest rates and raised short-term rates in December. However, we think there are a number of issues in the U.S. and internationally that could be problems for the U.S. economy in the near term. Fourth-quarter gross domestic product is expected to grow at about 1%, down from 2% in third quarter and almost 4% in the second. Commodities prices have been declining the past few months and have not stabilized. Internationally, China’s growth rate has slowed and much of Europe teeters near recession.
- We believe there is a clear divergence in the policies of the Fed and other central banks around the world. The Fed has started monetary tightening while nearly every other central bank is easing and trying to spur demand through quantitative easing, lower or negative interest rates, currency devaluation or combinations of these.
- The Fund maintained its short duration posture relative to the benchmark throughout the quarter. The belief that interest rates would move marginally higher as the Fed rate hikes approached played out during the quarter. In addition, the Fund was positioned to benefit slightly from a yield curve flattening. However, taking out-sized positions based on overall duration and the shape of the yield curve did not seem prudent during the quarter. The overall duration of the Fund did not change significantly.
- With expectations that the Fed will continue to raise short term rates and there will be less than robust global economic growth, many investors think the Treasury yield curve will continue to flatten in the coming months. Therefore, we are likely to position the Fund to perform better in a yield curveflattening environment. This is likely to involve extending duration on some Treasury positions. In addition, we expect to increase the Fund’s exposure to mortgage-backed securities when opportunities arise, attempting to avoid mortgages that add much durationextension risk.
- The Fed is expected to increase shortterm rates gradually in 2016, likely in two to three rate hikes, depending on economic data. If the Fed executes on its stated gradual pace, we think the yield curve will continue to flatten throughout the year and not be particularly disruptive. However, there is a significant risk that the Fed will act in a way inconsistent with market expectations, which would likely lead to market turbulence.
- The lack of coordinated central bank policies may slow the Fed's plans to tighten the money supply. Consensus amoung Fed watches is that the Fed will raise rates three or four times in 2016, while the bond market is anticipating two hikes. It is important to keep in mind that three rate increases in 2016 the magnitude of December's increase still would raise the fed fund rates target to only 1.25%. That is a very low rate historically.
- It is nearly impossible to predict the future path of interest rates, given the Fed's unwinding of its long-held zero interest rate policy. It becomes even more difficult when considering other central bank policies outside of the U.S. may actually be inconsistent with the Fed's announced strategy
The opinions expressed in this commentary are those of the Portfolio's managers and are current through Dec. 31, 2015. The managers' views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. Past performance is no guarantee of future results.
Risk factors. As with any fund, the value of the Portfolio's shares will change, and you could lose money on your investment. An investment in the Portfolio is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Portfolio may fall as interest rate rise. These and other risks are more fully described in the Portfolio's prospectus.
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