Coming Week: Fed Trick or Treat

"As long as inflation expectations hold in check, rate cuts will be an elixir gladly chugged by investors," says Randy Diamond, trader at Miller Tabak. Many market participants noted that the Fed's surprise 50-basis-point rate cut in September signaled a white flag to the markets that the goals had shifted from inflation-fighting to confidence-boosting.

The Fed had been attempting to restore the seized-up credit markets to normal with liquidity injections and a cut to the Fed's last-ditch liquidity source, the discount window.

The Treasury bond market, too, is pricing in about 75 basis points more of Federal Reserve easing. The government securities have rallied all week, sending yields down, as investors flee from riskier assets into so-called safe Treasury bonds. The flight to quality has led the 10-year note to touch a nearly two-year low earlier this week to yield 4.32%. It ended Thursday at 4.37%.

As Matus says, the Fed's inclination to ease these days is "not so much a positive but about avoiding a negative." The prior rate cut did help restore some movement to the credit markets. The high-yield bond and leveraged loan markets are slowly but surely swallowing the massive pipeline leftover from the past year's M&A boom. The high-yield bond market this week priced the largest ever junk bond in the form of a $7.5 billion package tied to the leveraged buyout of Texas utility TXU.

Rates on short-term commercial paper are coming back to normal, and even three-month Libor has fallen, though it still remains elevated at 5.01%, compared with the current 4.75% fed funds target rate. Three-month Libor is the market-driven interest rate tied to most mortgages, and to trillions of dollars worth of loan derivatives, deposits and other financial instruments.

But the problems of Citigroup or other banks' SIVs, or Merrill Lynch's asset writedowns, are tied to the mortgage-backed securities market -- which remains troubled. The ratings agencies have made more ratings downgrades in recent weeks and the indices tied to these securities are down near their August levels or below, after a brief rebound in September.

More rate cuts do steepen the yield curve, which helps banks that borrow in the short-term markets and lend out at longer, higher rates, meaning they have what's called positive carry. But "any rate cut will be muted in the real world" until investors believe there's a rescue for the SIVs and the banks, says James Bianco, president of Bianco Research.

The problem there is that the excess liquidity that a fed funds rate cut generates doesn't usually move into the worst parts of the market. Portales Partners analyst Charles Peabody explained in a late September interview with Kathryn Welling, publisher of the journal welling@weeden, that the rate cut is not necessarily effective because "liquidity seeks out the inflating, not the deflating asset."

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