Long Term Perspective

The spread between the 5-year Treasury note and the federal funds rate averaged minus 189 basis points in the 1980s. This was a period of high interest rates and (relatively) high inflation. The spread became positive in the 1990s, averaging 116 basis points.

The spread between the 5-year note yield and the federal funds rate averaged 103 basis points between 2000 and 2006. The average spread stood at 83 basis points in 2005, but fell to minus 22 basis points in 2006 as more investors in the bond market then came to expect the Fed to ease by mid-2007 – only to be disappointed until much later in the year.

Short Term Perspective

It is not unusual to see average yields on 5-year notes to run at least 100 basis points over the fed funds rate target – least during periods of stability in monetary policy stance. During periods when there are expectations of change in monetary policy, this spread can change significantly. As economic conditions improved in 2003 and 2004, bond investors expected that Federal Reserve officials would increase the fed funds rate target from its historically low rate of 1 percent. The Fed did not begin to increase the funds rate target until June 2004. Rate hikes in 2004, 2005, and into 2006 were anticipated by market players and did not come as a surprise at any point in time. Even though the Fed cut the fed funds target rate by 100 basis points during the latter part of 2007 (including December 11), the 5-year note rate is still running below the fed funds rate, indicating market expectations of further rate cuts. Flight to quality over subprime losses by numerous lenders and holders of subprime debt also played a role in the low yields on Treasuries.

Average yields on 5-year notes decreased 53 basis points in November to 3.67 percent.

Values shown reflect monthly averages.