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 – though the markets have continually been disappointed during 2007.

Short Term Perspective

The spread between the 2-year note yield and the fed funds rate fell to minus 116 in November from minus 78 basis points in October. The 2-year note yield dropped 63 basis points to 3.34 percent for the month while the fed funds rate target was down 25 basis points to 4.50 percent on a monthly average basis. The decline in the spread is due largely to flight to quality over subprime concerns.