Long Term Perspective
In the 1980s, the spread between the 7-year note yield and the federal funds rate averaged -183 basis points. The 1980s was generally a period of high interest rates and relatively high inflation - at least in the first half of the decade. The spread turned around in the 1990s and averaged +138 basis points (where 7-year note yields were higher than the funds rate).

The spread between the 7-year note yield and the federal funds rate averaged 157 basis points from 2000 to 2005. The spread averaged 252 basis points in 2004 but declined to 94 basis points in 2005.

Short Term Perspective
Economic activity began to show pronounced improvement in 2003 and bond investors began to expect that the Federal Reserve would begin to raise the federal funds rate from its historically low rate of 1 percent. In fact, the Fed didn't begin to raise rates until mid-2004. Economic conditions were generally healthy in 2005 as well, and some feared inflationary pressures coming from the energy sector would spill over to the non-energy sector. Consequently, investors anticipated all the Fed rate hikes in 2005.

The average 7-year note yield decreased 22 basis points in August to 4.83 percent.