No light at the end of the tunnel
Irrational behavior appears to be the name of the game. When the February employment report came out slightly stronger than expected, market players were disappointed because it meant that the Fed would not ease aggressively. The report didn't mean that the Fed wouldn't ease at all, but bond and equity investors came to the conclusion that only a 50 basis point rate cut was in the cards. This week, equity investors became convinced that the weak economy would generate a poor outlook for corporate profits. Somehow, this doesn't quite mesh with the stronger-than-expected employment report. If employment were on the mend, then stock investors should be pleased with an improved economic and profit growth outlook. Instead, equity investors are worried that corporate profits will be sluggish through the first half of the year - and perhaps into the second half of the year as well.

Consequently, markets tumbled this past week - almost in a freefall. The Dow Jones Industrials fell below the 10,000 level for the first time since last October. The Nasdaq composite index has been declining even more rapidly these past few weeks. The S&P 500 index now incorporates a good chunk of technology firms. As a result, this index has declined much more rapidly than the Dow or even the Russell 2000. Granted, it hasn't declined as quickly as the Nasdaq composite index. Note how much each of these major indices has declined since the beginning of the year.

Apart from an anemic manufacturing sector and a drop in consumer optimism, most economic indicators are not pointing to a poor economic environment. If it were only for economic indicators, the Fed could very well get by with a mere 50 basis point reduction at the FOMC meeting on Tuesday. Ironically, the bearish market psychology may contribute to a larger interest rate cut in the next few weeks. The Fed may choose to reduce rates sharply at once, or space them apart by a few weeks. Given the current environment, one big cut (75 or 100 basis points) could be the shot in the arm that this market needs.

Treasury yields fall in flight to quality bid
Treasury yields always benefit when concerns about economic conditions come to the forefront. The yield on the 30-year bond edged down this past week, but not very much relative to the declines across the maturity spectrum. Yields fell much more sharply among 2-year, 5-year and 10-year notes. To some extent, the drop in yields reflects the flight-to-quality bid as investors flee high-risk equities for the risk-free Treasury security sector. In addition, bond investors have factored in a Fed rate cut - probably in excess of the 50 basis points expected until recently. It isn't unusual for expectations to become more optimistic (rather unrealistic) as the date of the FOMC meeting approaches. Unfortunately, this only serves to dash expectations and cause prices to tumble afterward.