SAN FRANCISCO -- As expected, the

Federal Reserve

lowered its key lending rates by 25 basis points today. Somewhat unexpectedly, the

accompanying statement indicated the Fed is likely to continue cutting rates going forward.

"Economic activity remains soft, with underlying inflation likely to edge lower from relatively modest levels," the central bank said. "To be sure, weakness in demand shows signs of abating, but those signs are preliminary and tentative."

Given that, the Fed's Open Market Committee reiterated its longstanding belief that "the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future."

After rallying initially in the wake of the Fed's action, the stock market drooped in the final hour of trading, a move exacerbated by a profit warning from

Merck

(MRK) - Get Report

.

Once as high as 10,015.90, the

Dow Jones Industrial Average

closed down 0.3% at 9888.37. The

S&P 500

slid 0.3% to 1136.76 vs. its intraday best of 1150.89. The

Nasdaq Composite

rose 0.5% to 2001.93 but was down from its apex of 2032.63.

The Fed's statement gave pause to the recovery theory, which had been gaining in popularity, as evidenced by today's story in

The Wall Street Journal

about optimistic economists. More concrete evidence that the slowdown remains very much alive came from Merck's sharply lowered earnings guidance.

"I think people are starting to realize the economy is in worse shape" than had been hoped, said Bob Basel, director of listed trading at Salomon Smith Barney. Merck's announcement caused traders to worry over "how many other groups could be in a similar situation."

Merck's news "didn't help" but was less important than the Fed's statement, Basel contended. "People were undecided what the bias would be going forward, and when you got the 25 basis-point cut, you got a rally," he said. "But how many times can you cut rates in the course of one year?"

Ironically, it may turn out to be that investors started losing faith in the Fed's abilities just about the time rate cuts were starting to have some effect.

While equity participants fret the recovery may not be believable, fixed-income traders worry the Fed already has done more than enough to stimulate the economy. Such concerns were evident in the recent rise in yields of long-dated Treasury securities.

In fact, the yield on the 10-year note rose 98 basis points for the month ended Friday, the biggest one-month rise since early 1987, according to James Bianco, president of Bianco Research in Barrington, Ill. Bianco also noted that, unlike during stock market rallies earlier this year, the bond market, currency market and even commodity prices are also supporting the recovery scenario.

Today, the long end of the Treasury bond market moved inversely to the stock market, rising early, then falling in the wake of the Fed's announcement before rallying late as stocks sagged. The price of the benchmark 10-year note rose 7/32, to 99 15/32, its yield falling to 5.07%.

The bond market's post-Fed dip reflected disappointment that the FOMC didn't indicate it would soon be moving toward a neutral bias.

"I think market participants continue to try and find

reasons why the Fed is done, but the Fed says 'we know the job's not done,'" said one bond market participant. "They're going to flood the market with liquidity and are not concerned about pushing on a string because we don't have the financial system problems as in Japan."

The trader, who requested anonymity, suggested the recent rise in bond yields had more to do with selling by participants in the mortgage-backed market vs. expectations of future Fed action. Still, "as you get closer to the end of a cycle, everyone wants to be a sage and be the guy who first foresaw when interest rates would start to rise," he said. "I think it's very unlikely the Fed starts tightening before GDP is above 2%, which seems unlikely before the third quarter of next year."

Who's Zooming Whom?

The aforementioned is based on a view that the Fed dictates market action. But to Bianco, the precise opposite is true.

Notwithstanding the statement, Bianco noted the Fed has to be close to being done cutting rates, according to both "the law of numbers" and the spread between the two-year note and the fed funds rate, now at 123 basis points. The fed funds rate is now at 1.75%, its lowest level in 40 years, and the two-year note is yielding 2.98%.

Earlier in the year, the two-year note's yield remained stubbornly below the fed funds rate even as the Fed was aggressively cutting rates. That was a message for the Fed to keep on easing, according to Bianco. Now, the two-year note, as well as the eurodollar futures contract, are suggesting otherwise.

"The market isn't that far from the 150-to-175

basis-point range, which would imply they're demanding the Fed raise rates," he said. "I would not be surprised if within 90 days we're talking about tightening. If the market tells Greenspan to do it, sooner or later he will eventually listen."

Most observers believe the Fed is a long way from tightening, "because there's no conceivable way they can see it," especially after today's statement, he said. "But what does Greenspan defer to? The market is going to force everyone to come to its point of view, which is the way Greenspan has worked, vs. the other way around."

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.