Several forces came together last week to halt the stock market rally dead in its tracks. On Tuesday, long-term Treasury rates touched a 5-year low of 9.15 percent while the stock market moved to an all time high of 1565.71. On Wednesday morning, the Commerce Department released the news that unemployment had fallen from 7.0 percent to 6.9 percent, as civilian employment climbed by 320,000. Much to the surprise of traders, investors and analysts, an anemic economy suddenly seemed to be more healthy than anyone had envisioned. The investment world now realized that the Federal Reserve, in the face of a stronger economy and an accommodative monetary policy, was in no position to lower the discount rate from its present 7.50 percent level.

The trouble was, the market had convinced itself that the discount rate would decline, and had adjusted itself to a lower discount rate. Market participants then looked at the cost of overnight money as measured by the federal funds rate and, at best, with no cut in the discount rate, figured the Fed funds rate to be 7.75 percent. Using the federal funds rate as a base rate, history would indicate that at a minimum, the 2-year note should return 75 basis points more yield than the federal funds rate, or 8.50 percent (a basis point is 1/100th of a percentage point). The problem was, an overzealous market had the 2-year note returning 8.08 percent.

To add fuel to the fire, the Treasury auctioned $6.5 billion of 7-year notes on Tuesday and $4.75 billion of 20-year bonds on Wednesday. Government bond dealers purchased 86 percent of the note and 95 percent of the bond hoping to resell them to clients. If calculated from the average purchase price of each issue, by Thursday afternoon, the 7-year had a loss of $13 per $1,000 note, while the 20-year had a loss of $16 per $1,000 bond. If the market does not recover by settlement or payment date, Jan. 15, the dealers will begin the new year with horrendous losses.

Finally, as market psychology changed in a minute and bond prices began to plummet, those investors who follow charts were given "sell" signals as bond prices zoomed through trigger "sell" points on their charts. This caused heavy retail selling to dealers who were in the process of being saddled with securities from the two auctions. After this wholesale blood-letting, it will take some time for the market to right itself and for prices to advance further.