Investors also recognize that the Fed’s rate forecasts are conditioned by their projections for economic growth. They are currently forecasting relatively slow growth through 2014, hence their view that the economy will need the support of exceptionally stimulative monetary policies. Should those forecasts prove to be overly pessimistic, policy might not stay unchanged as long as the Fed now predicts. Investors know that the Fed’s economic forecasts are just as fallible as anyone’s, which is why bond yields react to swings in the tenor of the economic indicators. Last spring/summer, many of those indicators appeared to be weakening and the bond markets rallied. In recent weeks, most of those indicators have improved. It appears that the economy began 2012 with good positive momentum. The release of somewhat better economic data during January, plus some signs of better markets in Europe, produced a mild increase in Treasury market yields despite the Fed’s efforts to the contrary.

It appears, therefore, that the outlook for bond yields is no clearer now than it was before the latest FOMC meeting. Future bond market performance will still be dictated by the tenor of the domestic economic indicators and by developments in Europe. Currently, both factors appear to be more encouraging than during the second half of 2011. If those improving trends are sustained in the months ahead, Treasury yields could increase further. For those yields to decline substantially in 2012 would probably require a worsening of the crisis in Europe and/or a near-recession in the U.S. Neither is likely in our view.

This would imply that the Treasury market and those sectors most closely associated with Treasuries—agency notes and bond, TIPS and mortgage-backed securities—are likely to underperform those markets that offer relatively generous yield spreads to Treasuries. In the investment grade taxable area, corporate bonds rated BBB and bank and finance issues still offer generous spreads to Treasuries. It is noteworthy that in January those were the best-performing segments of the investment grade corporate market.

The high yield corporate market performed best among taxable markets, as would be expected for a period in which equities performed well. The high yield bond market has recovered impressively from a very severe third-quarter setback. Because yields rose so sharply in the third quarter, even after four months of recovery, yield spreads to Treasuries remain substantially wider than in past periods of improving credit fundamentals. Also, because there is considerable room for those spreads to narrow if Treasury yields were to rise, the high yield market could continue to post better total returns than Treasuries in the months ahead.

Several segments of the municipal market still offer generous yields relative to Treasuries. The strong municipal market rally the past three months has brought AAA yields to below or about even with Treasury yields. In the A/BBB credit sectors, yields remain substantially higher than Treasury yields. We continue to recommend those segments rather than the top-rated segments of the muni market. It might be prudent, however, to wait a few more weeks before committing funds to these sectors. The municipal market supply calendars are always light in January and usually start to build in February-March. More representative new issue calendars might result in somewhat higher yields toward the end of this quarter.

Conclusion
These strategic recommendations are very similar to those we presented in mid-December in our 2012 Outlook report. The Fed has gotten lots of headlines with the announcements suggesting low rates over an even longer investment horizon. The markets recognize that while these are important pronouncements, yields on Treasury notes and bonds are already exceptionally low, perhaps incorporating fully those rate expectations. Moreover, other factors that affect bond yields are highly uncertain. Thus, in the months ahead, Treasury bonds might not perform as well as the Fed announcements might suggest. We continue to believe that the markets we have been recommending offer better value than Treasuries and should continue to perform better than Treasuries during the remainder of 2012.