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 minus 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 42 basis points from 2000 to 2006. The average spread dropped to minus 15 basis points in 2006 from a +64 basis point average in 2005.

Short Term Perspective

Before 2003, investors were still concerned about the state of the economy coming out of recession. 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 and eventually turned negative in 2006 as investors began to think in terms of the Fed easing in the near future. However, a rebound in core inflation early in 2007 kept the Fed on hold initially but easing in core inflation at mid-year and the subprime credit crunch tipped the balance for the Fed to begin easing on September 18.

Due to the Fed easing and due to flight to quality, the 2-year note yield fell 66 basis points in November to 3.35 percent. The average yield was below the funds rate target for the sixteenth straight month, indicating that markets still expect further interest rate cuts by the Fed, one of which did occur on December 11.

Values shown reflect monthly averages.