Long Term Perspective
The spread between the 3-year Treasury note and the federal funds rate averaged -181 basis points in the 1980s when interest rate levels were generally much higher than they are today. The spread turned around in the 1990s to average +83 basis points.

The spread between the 3-year note and the federal funds rate averaged 78 basis points from 2000 to 2005. In a similar fashion to the 2-year note, the spread fell to 71 basis points in 2005 from 143 basis points in 2004.

Short Term Perspective
In 2003, economic conditions were generally healthy and bond investors became less worried about the state of the economy and began to worry instead about the potential for inflationary pressures as the economy expanded. They knew that the Fed would want to prevent inflation expectations to develop and that the Fed would need to raise the fed funds rate target from its historically low rate of 1 percent. Thus, the spread between the 3-year note yield and the fed funds rate widened as investors anticipated a rate hike that did not come until June 2004. Generally, all the fed rate hikes in 2004 and 2005 were well anticipated by market players.

The average yield on the 3-year note fell 22 basis points in August to 4.85 percent - below the fed funds rate average for the second straight month. After the Fed left its target rate unchanged at the August 8 FOMC meeting, bond investors became less certain that the Fed would raise rates this year.