Market's reaction to Fed rate cut

By Mark Hulbert,
Last Update: 1:13 AM ET June 27, 2003

Most investors are considering that decline in the Dow ($INDU: news, chart,
profile) to be nothing more than an example of the old adage "buy on the
rumor, sell on the news."

But there is a more ominous possibility: The economy may be a lot weaker
than originally thought, with a deflationary collapse a real possibility. On
this theory, the stock market fell because it was disappointed that the Fed
didn't cut rates by 50 rather than 25 basis points.

Support for this less favorable interpretation comes from several different
quarters. Consider the trading history of a novel futures contract that,
until the day of the Fed's announcement, traded at a Dublin-based futures
Web site known as

This contract would have paid $10 if the Fed had reduced interest rates by
50 basis points; as it turned out, because the Fed didn't cut rates by that
much, it paid nothing.

Because it was thus an "all or nothing" contract, its trading price at any
given time reflected the market's collective judgment of a 50-basis-point
rate cut.

Its last trades prior to the Fed's Wednesday announcement were between $3.20
and $3.50 per contract, reflecting the market's judgment that there was
between a 32 percent and 35 percent probability that the Fed would approve
the half-point cut.

The stock market's level prior to the Fed's announcement thus already
reflected around a one-in-three probability that the Fed would approve a
half point cut. Because the market dropped 100 points upon learning that the
Fed would not approve the larger cut, we can infer that the market thought
that, all told, a 50-basis-point cut was worth about 300 points.

We therefore can guesstimate that if the Fed had approved a full half-point
cut, the market would have risen 200 points instead of falling 100.

And that's remarkable. It reflects a stock market that is preoccupied --
obsessed, really -- with profound economic weakness.

Otherwise, why would stocks rally in the face of what -- had it come to
pass -- could only have been characterized as a desperate action?

Richard Russell of Dow Theory Letters explains: "massive amounts of debt
have been built into the US economy. In fact, the debt structure is now so
incredibly high (over $30 trillion) that there is no room for correction,
backing off, normal retrenchment following the great bubble boom. So it's
the old story... INFLATE OR DIE. And so, dear subscribers, we better

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