Rate cut doesn't help equity market
Stock prices were moving in the right direction in the first half of the week - until the Fed cut the funds rate target by 50 basis points, not the 25 that was expected. The immediate reaction was negative in the equity market, although prices did end Wednesday higher. But equity investors showed their dissatisfaction on Thursday and Friday when prices trended lower and ended the week no better off than the previous one. While conventional wisdom says that a Fed rate cut is positive for equity prices, that is not always true. Lower rates are often accompanied by a weak economy. Equity investors were already worried about the sluggish pace of the recovery before. The aggressive move has raised worries that the Fed sees more bad news on the horizon. The equity market would be much better off if economic activity, along with corporate profits, improved. In a weak economy, stock prices will benefit more from higher profits than lower interest rates.

Some Treasuries rally on Fed rate cut
Bond investors were looking for a rate cut, that's true, but were surprised by the 50 basis point cut. Based on the changes in the Treasury yield curve, it seems that the long end and short end of the market benefited differently from the rate cut this week. For instance, the chart below shows that the yield on the 10-year note dropped by 23 basis points from Tuesday (before the Fed action) to Friday. However, the change since last Friday was somewhat smaller since yields increased in the first half of this week.

The yield on the 5-year Treasury dropped 20 basis points from Tuesday to Friday. However, note that yields were on a rising trend from last Friday through Wednesday. Oddly enough, the yield rose on Wednesday after the rate-cut announcement. Security prices rallied on Thursday and Friday, though. After all was said and done, the 5-year note yield was 2 basis points higher than last Friday!

Judging by the yield on the 2-year note, where yields are higher this week than last, one would never know the Fed cut rates! This underscores the problem that the Fed faces when it makes policy decisions. Sometimes rates will move in the same direction and by the same magnitude as the federal funds rate, but other times market players have a different view how the economy will react to a Fed move. It is worth noting, in all cases (10-year, 5-year and 2-year) the yields dropped about a week before the Fed actually announced its cut, in anticipation of the Fed action. However, given that the Fed moved more dramatically than expected, one still would have thought yields across the maturity spectrum would have rallied at least a little.