How do rate cuts affect near-term market psychology?
The Federal Reserve has reduced the federal funds rate target by a total of 250 basis points so far this year, bringing the federal funds rate target down to 4 percent on May 15. For the most part, one would expect equity and bond investors to rally joyously each time the Fed cuts rates. Indeed, we have seen quite a run-up in stock prices on most of the days that the Fed cut rates. Yields on bonds didn't always fall dramatically on those days, but often this was because the rate cut was fully anticipated. Yields have been falling in the days prior to Fed actions.

In the past week, as economic data fluctuated between healthy, lackluster and downright recessionary, market players vacillated between expecting a rate cut of 25 and 50 basis points. For instance, the plunge in April payrolls and seven consecutive declines in industrial production supported the more aggressive move. But some market players interpreted the retail sales and consumer confidence data as relatively healthy and believed that a 25 basis point reduction would be more likely.

The Fed remained not only aggressive in their easing on Tuesday but also implied that further rate cuts are not out of the question, maintaining that economic weakness is their concern for the future. One would have expected a greater exuberance on the part of equity and bond investors after the announcement. Why was the reaction so subdued in the stock market? So negative in the bond market (bond yields rose)?

Bond market psychology
While both the bond and equity markets build in expectations for Fed actions, the bond market usually is a pretty good anticipator of Fed actions. As a result, we are likely to see declines in bond yields long before the actual announcement of a Fed rate cut. In the past month, bond prices were more likely to go down than up (meaning higher yields) as market players began to anticipate the end of Fed rate cuts by the end of the second quarter. In addition, bond investors are becoming more concerned about inflation. Inflation has not accelerated dramatically in the past six months, but its upward creep has heightened fears.

The psychology in the bond market has tended to be more negative recently. The economic figures reported over the next couple of weeks will certainly play a major role whether the psychology turns around. A few more anemic economic figures coupled with friendly inflation news will go a long way in curtailing some of the inflation fears in this market.

Stock market psychology
The stock market certainly celebrated the last time the Fed cut rates on April 18. Prices did get a boost on some of the other occasions in which the Fed announced rate cuts this year, but not on all of them. Some of this puzzling behavior may be related to the fact that stock prices sometimes rose the day before or the day after the Fed announcement, as investors either anticipated the news or took a day to digest its meaning.

Stock investors are also affected by poor inflation prospects, but this isn't their current fear. Instead, equity investors are more worried about the prospects for greater economic weakness. While companies - and therefore stock prices - benefit from lower interest rates, they are of course no less concerned with corporate profits. It is very hard for profits to rise when the economy is not growing and when companies aren't generating revenues.

While low inflation numbers are good for equity investors, this market will tend to be more bullish if the prospects for economic growth improve. In this case, they will be at odds with their brethren in the bond market.

The bottom line
It is very possible that the psychology in both markets is negative but it would be for different reasons: inflation fears for bonds, economic weakness for equities. It is also possible that psychology will improve and one or the other moves higher. But given that bond investors will prefer weak economic data at the same time that stock investors prefer strong economic data, the likelihood is high that the markets will not be moving higher together.

Evelina M. Tainer, Chief Economist, Econoday