Long Term Perspective
A period of high inflation and high interest rates caused the spread between the 2-year Treasury note and the federal funds rate to average -150 basis points in the 1980s. This means that the overnight federal funds rate was higher than the 2-year note over a large part of this decade. In the 1990s, however, the spread was +62 basis points - that is, the yield on the 2-year note was higher than the fed funds rate.

The spread between the 2-year note and the federal funds rate averaged 52 basis points from 2000 to 2005. The average spread dropped to 64 basis points in 2005 from a 103 basis point average in 2004. The spread was lower from 2000 to 2002.

Short Term Perspective
Before 2003, investors were still concerned about the state of the economy. However, economic conditions improved and bond investors began to expect the Federal Reserve to raise its fed funds rate target from the historically low level of 1 percent. As the Fed refrained from raising its target rate, investors were becoming more and more convinced that they would eventually increase this rate and yields on the 2-year note surpassed the funds rate target by an increasing margin in 2003 and 2004. By 2005, bond investors were no longer looking for increases to continue indefinitely and the rate differential began to subside.

The 2-year note yield declined 22 basis points in August to 4.90. The average yield was below the funds rate target for the second straight month, and this suggests that investors have shifted their expectations on future Fed rate hikes. The FOMC left the funds rate target unchanged at the August 8 meeting and investors are no longer sure whether or not the Fed will raise rates again this year or not.