Long Term Perspective

During the 1980s, there were large swings in the spread between the 2-year Treasury note and the federal funds rate due to slowly declining inflation expectations. But this spread averaged 15 basis points in the 1980s. In the 1990s, the spread rose to plus 62 basis points.

 

The spread between the 2-year note and the federal funds rate averaged 32 basis points from 2000 to 2014. The average spread rose 17 basis points from 2013 to 2014 to 37 basis points.  Over the last decade, economic concerns have changed dramatically. 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 in 2003 and early 2004, 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 an easing in core inflation at mid-year and the subprime credit crunch tipped the balance for the Fed to begin easing on September 18, 2007 and through late 2008.  Recession fears led the Fed to cut its policy rate in 2007 and 2008.  A weak economy and flight to safety pulled the 2-year yield down and it remained low into early 2013 despite a mild economic recovery.  Quantitative easing has played a key role in keeping mid-term rates down along with Fed guidance on rates.  But the end of quantitative easing has led to some firming in Treasury note rates.

 

 

Short Term Perspective

The 2-year note has been a favorite of many during flight to safety.  But what pulled the rate down at mid-2011 was the Fed's announcement on August 9, 2011 that it would keep the fed funds rate exceptionally low at least until mid-2013.  And the Fed extended that guidance to mid-2015 at the September 12-13, 2012 FOMC meeting.  Now the Fed bases guidance on labor market measures and inflation expectations and stating that it will be patient in making the first rate hike.  Fed forecasts through the December 2014 FOMC meeting left guidance comparable to a mid-2015 date.  Fed chair Janet Yellen in her February testimony before Congress indicated that no rate hike is likely before June 2015.  Most recently, the April Beige Book was dovish along with most FedSpeak also being dovish.  Given that the Fed would only gradually boost fed funds even after mid-2015 (at the likely earliest), the 2-year note now is acting much like a T-bill.   The two-year note stood at 0.64 percent in March—up 2 basis points from the prior month.

 

 

Values shown reflect monthly averages.