Long Term Perspective

Fluctuating yield differentials between the 2-year note and the 10-year note reflect changes in the economic environment. When the spread between these two securities has narrowed, it has historically reflected softening in economic activity – and sometimes even recession. When the spread widens, it reflects a period of stronger economic growth. The gap between 10-year and 2-year note yields widened in 2002 and 2003 suggesting economic growth was on the horizon. In 2004, the gap narrowed as the yield curve flattened. The spread narrowed further in 2005 and 2006 and has been nonexistent during 2007 with the 2-year note even edging incrementally above the 10-year yield. Flight to quality over subprime concerns during the second half of 2007 kept rates low along with the belief that the Fed would be easing further. Another view is that the bond market believes that the Fed will clamp down on inflation whenever necessary. The Fed’s credibility keeps the long bond inflation premium low.

Short Term Perspective

The Fed cut the fed funds target rate by 50 basis points on September 18 and then by 25 basis points on October 31. In November, yields on both the 2-year note and 10-year bond declined by 63 basis points and 38 basis points, respectively. This dip in rates reflected both a flight to quality due to the recent concerns over the quality of subprime loans and an expectation that the Fed would be easing at the December 11, 2007 FOMC meeting.  Long-rates also have come down due to weaker economic data.