Long Term Perspective
Often, one can get a sense of market expectations by looking at the spread between the 2-year note yield and the fed funds rate. When the spread narrows, or even turns negative, it means that market participants expect the Fed to ease monetary policy. When the spread widens, market participants are looking for tighter monetary policy. The spread has fallen sharply since 2004. Both rates rose until August 2006 when the Fed stopped tightening. However, the 2-year note did not rise as sharply and even softened starting in October. During 2004 through mid-2006, the markets did not appear to anticipate how much the Fed would tighten. Declines in the spread since August 2006 indicate that the markets expect lower interest rates in coming quarters.

Short Term Perspective
The spread between the 2-year note yield and the fed funds rate fell to -51 basis points in November. The 2-year note yield declined 6 basis points to 4.74 percent for the month, but the fed funds rate target remained unchanged at 5.25 percent. The decline in the spread is due to a fall in the 2-year note related to expectations that the Fed will ease no later than mid-2007. Markets have been wrong before, but note rates are lower since short rates are expected to be much lower. Otherwise, the markets could continue to buy short rates and roll them over instead of buying 2-year notes.