SAN FRANCISCO -- Could it be, after 10 rate cuts totaling 450 basis points, investors are losing their faith in the

Federal Reserve's

magic powers? Or, at least, they have realized that Fed easing isn't the panacea for what is currently ailing the economy, namely a huge slowdown in corporate spending after the massive overbuilding of the late 1990s?

One could make that assumption as major averages slid today -- the

Dow Jones Industrial Average

fell 1.3% to below 10,000, the

S&P 500

slid 1.6% and the

Nasdaq Composite

lost 1.4% to below 2000 -- ahead of what is widely expected to be another 25 basis-point rate cut tomorrow.

But as Felix Unger once taught a generation of fans of

The Odd Couple

, making assumptions is a fool's paradise.

"There had been a loss of confidence

in the central bank until the Fed stepped it up again this fall" after Sept. 11, said Tony Crescenzi, chief bond market strategist at Miller Tabak. "It's a leap of faith people seem willing to want to make right now," as evinced by the strength in economically sensitive stocks and narrowing of spreads between corporate bonds and Treasuries.

The recent performance of stocks and corporate bonds is indicative of investors being less risk-averse, Crescenzi said, describing the current mindset as a "second round of optimism" in

Alan Greenspan & Co. While risk aversion is necessary for the economy to emerge from recession, he cautioned "whether or not it's justified" remains to be seen.

Indicators such as falling inventories, rising new orders (both in the NAPM surveys and durable goods report) and ongoing strength in consumer spending "lend credence to the argument the economy will rebound," the bond strategist said. "But evidence of a pickup is still not substantial yet."

The big risk is that consumer spending evaporates unless the deterioration in the labor market at least stabilizes, if not actually improves. Less obvious is that the recent rise in bond yields is putting a crimp in mortgage refinancing activity, which will cut off a big source of consumers' discretionary cash flow. (Refinancing activity was down 45% last week from record-setting levels in early November, the Mortgage Bankers Association of America reported.)

This gets to the issue of whether the recent rise in bond yields is going to choke off the recovery scenario in its gestation phase. (Today, however, the price of the benchmark 10-year Treasury rose 14/32 to 99 6/32, its yield falling to 5.16%.)

Bond Market Says What? Reprise

Long-term market movements reflect changes in investor expectations about inflation and/or the future level of short-term interest rates, according to Crescenzi. The current cycle appears to be an example of the "and" phenomena.

Regarding inflation, prior to the last Fed rate cut "bond investors were already worried about the sharp increase in money supply," which at 14% annualized for

M3 is the fastest pace since 1973, he said. "The message from the long end is that there's an expectation the economy will rebound sharply next year" with potential inflationary implications, because of all the fiscal stimuli.

Clearly, the sharp rebound scenario is one that stock market bulls have been espousing with glee. But as with the

valuation argument, equity optimists -- as is their wont -- are looking only at the rosy side of the bond market's message.

The other half of the story is that the short end of the bond market is increasingly pricing in a "large increase in the fed funds rate next year," Crescenzi said. Based on the December 2002 Euro-dollar contract, the market is expecting the fed funds rate to be 3.5% in 12 months; just a month ago, the expectation was for the key lending rate to be 2.50% to 2.75% next year, he noted.

The prospect of an aggressive Fed tightening cycle is something that has kept equity market skeptics from accepting the "new bull market" thesis.

"Political considerations probably require the Fed to continue the easing process, at least until Congress passes some kind of fiscal stimulus," commented Thomas McManus, equity portfolio strategist at Banc of America Securities. "But at some point, prospective tightening becomes a reality. After a while, rates themselves go higher,

and at current valuations, stocks seem unprepared for the eventuality."

Citing such concerns, McManus today lowered his recommended equity allocation to 55% from 60% while simultaneously lifting bonds to 40% from 35%; cash was unchanged at 5%.

Ominously, the strategist noted "the last time we saw such a dramatic rise in future fed funds

expectations was spring 1987."

Notably, McManus also made a thinly veiled reference to that infamous year in a recent

Streetside Chat with


But in a follow-up call Monday afternoon, the strategist said he is not forecasting the same fate will befall equities next year as in 1987. Rather, he believes "the Fed probably learned its lesson in 1987 and isn't about to let the financial markets get too far ahead of the economy."

That should translate into some cautionary commentary in the statement accompanying tomorrow's presumptive rate cut, McManus said, noting the five-year anniversary of Greenspan's famous "irrational exuberance" speech just past.

So perhaps the key question heading into Tuesday's meeting is whether investors are ready for the reality that the Fed isn't going to keep lowering rates at every meeting going forward. The market's response will say a lot about whether investors have truly kicked the rate-cut habit.

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

Aaron L. Task.