February 2011

Fixed Income Market Recap
From a point to point perspective, February appeared to be a rather calm month in the bond market. Yield-to-maturity of the 10-year Treasury Note ended the month 5 basis points higher than where it started and the yield curve was essentially unchanged. However, the intra-month volatility was anything but calm. In the first six trading sessions of February, the yield-to-maturity rose 35 basis points, shaving nearly 3% from the price of the 10-year Treasury Note. Heightened inflation worries and a continued improvement in the broad economy was the catalyst for the selling. However, those worries quickly faded as civil unrest in the Middle East prompted another round of flight to quality buying.

Economic Outlook
The economic data for the month was decidedly strong and reflective of a self-sustaining, accelerating economy. Initially, the employment report signaled otherwise, though. The headline non-farm payroll showed a disappointing gain of only 36,000 jobs for January. However, digging through the details revealed that the severe weather that gripped the Northeast and mid-Western United States distorted the number substantially. The February jobs data confirmed that with a solid increase of 192,000 workers and a drop of the unemployment rate to 8.9%. Clearly, the job market has improved and at this stage of the economic cycle, monthly job growth should be in excess of 150,000 per month.
Less ambiguous results were evident in the inflation indices. The Labor department reported that both the Producer and Consumer Price Index showed greater than expected year-over-year rates of change. With the risk of deflation fading, focus is quickly shifting to inflation, and to what level it may rise. We believe there is a complex dynamic at work that will likely cause inflation to rise faster than investors and economists currently assume. Specifically, the rapid growth in emerging market economies is creating a demand-pull situation in which their consumption of goods is bidding up prices and increasing the cost of goods sold. While the main culprits, China and India, are attempting to cool their economies, their actions have not yet had the desired effect. The second driver of inflation is likely to be housing. Because of the difficulty in measuring housing inflation on a monthly basis, the Bureau of Labor Statistics uses a measure called imputed rent as a proxy. A byproduct of the elevated level of foreclosures is an increasing demand for rental space which, in turn, has put upward pressure on rents. As the housing market improves, that upward pressure is likely to continue, which will contribute to upward pressure on inflation. To put it in perspective, imputed rent represents approximately 1/3 of the overall Consumer Price Index.
To summarize, the unemployment rate is falling, inflation rising, manufacturing is operating at multi-decade highs, the Dollar is weak relative to our main trading partners, and the Federal Reserve is printing money. We expect that the muted discussion surrounding QE2 will soon grow louder, and the Fed will come to been seen as falling behind in the need to drain liquidity. Given this backdrop, we believe that the fund is well positioned to perform in such an environment.