Perhaps off topic but interesting none the less:
Market's reaction to Fed rate cut
By Mark Hulbert, CBS.MarketWatch.com
Last Update: 1:13 AM ET June 27, 2003
ANNANDALE, Va. (CBS.MW) -- Why did the Dow Jones Industrials Average immediately drop 100 points after the Fed announced that it would reduce short-term interest rates by 25 basis points?
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 www.tradesports.com.
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 inflate."
