The Treasury market has been operational for four trading days and the stock market has now had two trading sessions. Prices of Treasury securities initially surged while yields fell on Thursday and Friday, but prices fell back on Monday and Tuesday (with yields rising). At the same time, the stock market plunged on Monday in its first day of trading with the Dow down about 7 percent. The Dow traded higher in the first half of the day's trading session but declined marginally at day's end.

Event driven action
Price fluctuations in the Treasury market on Thursday and Friday centered on the terrorist attack. That is, a flight to quality mentality develops in the early stages of uncertainty and prices of Treasury securities, a risk free asset, were driven up. If the stock market had opened sooner, it is possible that emotions would have driven share prices even lower. Given that investors had time to think about the eventual repercussions of the tragedy, it is likely that a smaller portion of the stock market movement on Monday was event driven. To a large extent, trading in the bond market and the stock market is now tied to people's perceptions of how the economy will now behave.

It hinges on consumer behavior
Consumer spending accounts for two-thirds of economic activity in the United States. A drop in consumer demand will no doubt hamper GDP growth. Some aspects of consumer spending are likely to be affected more dramatically than others. For instance, retailers likely saw little traffic during the week of the attack as Americans were glued to their TV sets. But as we try to settle back to normal, retailers are likely to see traffic pick up again. The extent to which retail sales grow in the next few months will certainly depend on consumers' expectations of their personal financial situation. Seeing the large number of layoffs in the airline industry, for example, may worry consumers about their own jobs and in turn dampen expenditure plans. However, if consumers feel that their own jobs are not in jeopardy at this time, they may be more willing to keep on spending.

Wherever consumer spending stabilizes, the kinds of things that consumers buy may change. For instance, the travel and leisure industry is showing the biggest loss in the stock market because airline executives, as well as investors, believe that consumers won't have the same propensity to travel as they did before. In a similar fashion, the prospect of less travel pushed stocks in the hotel industry sharply lower. Major casinos were particularly hard hit as less travel to Las Vegas would mean softer demand in this industry unless you are looking at local gambling areas such as riverboat casinos in Illinois, for instance.

The airline industry is not just expecting consumers to travel less for leisure, but business travel should also decrease somewhat. As a consequence, video-conferencing companies have posted strong performances.

Government Help
The federal government is helping to contain economic losses in a couple of ways. First, the Federal Reserve cut interest rates 50 basis points on Monday morning before the stock market opened. This brought the federal funds rate target to its lowest level since the beginning of 1994. Some market players are expecting the Fed to reduce rates again at their October 2 FOMC meeting. But even if they don't cut rates at that time, the Fed will surely stand ready to cut rates if necessary over the next couple of months. Furthermore, the Fed has been in an easing mode over the past year. Even without the September 11 attack on the World Trade Center and Pentagon, the impact of the previous Fed rate cuts wouldn't have been felt until late this year.

The federal government will also provide fiscal stimulus over the next several months. Congress immediately allocated $40 billion of emergency aid last week. There is no question that the nation's defense infrastructure will be re-built. Whether we are looking at missile systems or a new spy network, expenditures will increase and stimulate the economy.

Congress is also talking about an airline industry bailout; remember many airlines had been in trouble even before the attack. Continental Airlines has talked about declaring bankruptcy. A bailout plan will certainly keep the industry up and running. There is no question that this move is more controversial than some of the other proposals. Some of you may be old enough to remember that the airline industry was regulated until the late 1970s. Perhaps this is an industry that does best with a certain amount of government intervention. Many European airlines have close ties to their governments.

In addition to defense expenditures and emergency aid, government officials are also talking about further tax cuts to stimulate consumer and business spending. The lags from fiscal policy tend to be longer than those from monetary policy, but given this new environment, tax cuts are likely to help spur economic activity over the next year.

The bottom line? Government plans to stimulate the economy should be viewed in a favorable light by the equity market. If business activity grows, there is indeed hope for better profits at some point. Perhaps different industries will benefit more over the next year than we would have thought a week ago (video conferencing, surveillance technology, defense contractors). The outlook from the Treasury market will be somewhat different. Given an expectation of recessionary levels of activity, the Treasury market should not be excessively worried about inflation. However, the Treasury Department has cancelled some of its security buybacks for the next month. In addition, the higher level of government spending coupled with lower tax collections will probably mean that the projected budget surplus will be much smaller than expected. This is one reason why Treasury securities were selling off on Monday and Tuesday -- reversing the major market rallies that took place the first two trading sessions after the terrorist attack.

According to some reports, it appears that individual investors were not primarily responsible for the initial stock market sell-off on Monday. Indeed, many brokers noted that individuals who did call were placing buy orders. Many U.S. investors were simply acting patriotically. Many advisors stressed the wisdom that long-term investors should keep calm and not change their portfolios. After all, the companies in which they are invested will likely perform strongly in the next three to five years.

Evelina M. Tainer, Chief Economist, Econoday