The Federal Reserve raised its federal-funds target 425 basis points across 17 consecutive hikes from June 2004 to February 2007, moving from 1 percent to 5.25 percent. The 10-year Treasury yield stayed put: 4.73 percent in June 2004, 4.72 percent by February 2007.
Former Fed Chair Alan Greenspan called this disconnect a conundrum. Federal Reserve economists later confirmed that during this tightening, long-maturity yields and forward rates actually fell for extended periods.
The mechanism is straightforward: bond markets price expected Fed actions, not current ones. Yields fall today if investors expect a rate cut six months ahead, even if the central bank has not yet moved. A credible hike can drive long-term yields lower if markets conclude it will reduce future inflation.
Economists Cletus Coughlin and Daniel Thornton at the Federal Reserve Bank of St. Louis examined this dynamic. Once the federal-funds rate became the Fed's primary policy tool, it moved directly with policy changes. The 10-year Treasury, by contrast, responded independently to incoming economic data. The correlation between changes in the two rates approached zero.
From June 2006 to September 2007, the Fed held the funds rate steady at 5.25 percent while long-term yields swung sharply. An unchanged policy rate does not mean unchanged financial conditions across the curve. Market expectations and economic fundamentals drive the longer end.
Causality between the Fed and bond markets runs both directions. Markets continuously integrate information and anticipate policy shifts — they do not simply follow the central bank's lead.
