The markets are demanding another rate cut, and this week they're likely to get it.

Throughout the past week, investors in both stock and bond markets have shown how much they want more relief in the form of lower interest rates. Recently released economic data and Fed officials have put up no road blocks to suggest otherwise.

The question remains what good it will do for the struggling parts of the marketplace. Right now, the biggest questions along those lines are being asked about asset-backed securities tied to mortgages and the banks that hold them on their balance sheets or in off-balance-sheet funds -- including Merrill Lynch ( MER), Citigroup ( C), Bear Stearns ( BSC), Goldman Sachs ( GS) and Morgan Stanley ( MS).

According to the fed funds futures market, investors price in a 100% chance of a single 25-basis-point rate cut at Wednesday's meeting of the Federal Open Market Committee, according to Miller Tabak. There are just 8% odds of a 50-basis-point rate cut next week, going by Miller Tabak's numbers.

"Right now, the idea behind the Fed cutting rates is appeasing the markets," says Drew Matus, senior economist at Lehman Brothers. "Unless the Fed makes very clear they're done, the markets will force their hand over and over."

The stock market would clearly welcome more cuts. After being rocked by news of Merrill Lynch's staggering $7.9 billion writedown Wednesday, stocks rallied back from a sharp decline on a rumor that the Fed was convening an emergency meeting of the Federal Open Market Committee to slash interest rates.

"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."
In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click here to send her an email.