What next?

What a difference a day makes. Yesterday, it seemed like markets were in free fall, volumes were exceedingly heavy, and (eventually substantiated) rumours of Fed rate cuts were doing the rounds. Today, markets have stabilized, trading is quiet, and a patently ludicrous rumour of an emergency ECB easing is doing the rounds.

On the latter issue, as if yesterday's "stark" warning that inflation remains the ECB's primary concern weren't enough, this morning Jean-Claude Trichet passed up a chance to guide expectations lower. We now seem to have reverted to pre-2005 mode vis-a-vis the ECB, wherein the market apparently knows where the Bank is headed before the ECB itself does.

Regardless, markets are scratching their heads this morning and asking "what next?" As Macro Man writes, early session optimism has given way, and both equities and yen crosses are lower. A simple reading of the charts would suggest a decent prospect for a bounce; yesterday's candlestick formation is the same sort of "hammer" formation that marked an intermediate low in August. Macro Man would therefore not be surprised to see the SPX have a go at testing former support at 1360; an obvious pivot point to the downside is yesterday's low at 1274.
How best to play for a bounce, even if it's short-lived? Despite high levels of implieds, the current situation naturally lends itself to some optionality. Macro Man will therefore spend $250-$300k of premium on March 30-ish delta calls. The strike is 1375; if that seems rather far away, consider that we closed above that level just eight days ago. The trade will be executed at the CBOE open and jettisoned if the 1274 level gives way. We may well get some resolution when the Fed announces next week whether yesterday's action was an appetizer or the main course.

Elsewhere, yesterday's fixed income price action was curious, to say the least. To see the US curve steepen after the emergency 0.75% easing was hardly a surprise, but Macro Man was really struck by the furious rally in the back end in the New York afternoon- even as equities continued to claw back losses. Two-year note yields are now just 2% and look set on having a date with destiny, or at least the previous all time low yield of 1.06%.

A Dow theorist would look at a long-term chart of 2's and conclude that the long-term bull market remains intact, pointing to a series of lower highs (in yield) and lower lows. It does seem inevitable that 2's will at least attempt to revist the extremes of 2003, particularly if the Bernanke Fed continues to cut rates with such alacrity. Price action once we get to the sub 1.5% region will be very telling indeed, and could provide guidance on whether the ultimate outcome of the current crisis is Japan-style deflation or Macro Man's base case outcome of accelerating inflation.
Either way, Macro Man cannot bring himself to position for a further rally at the front end. He may be constitutionally unable to buy 2 year bonds with a nominal yield of 2% and a real yield of of -2%. He thought it would be interesting to put the aggressive easing conducted by the Bernanke Fed into persepctive. The chart below shows the real Fed funds rate and real 10 year yield since 1971, segregated into discrete time periods by Fed chairman.
Two things really stood out to Macro Man. The first is the remarkable synchronicity of the Fed funds and 10 year rates since Bernanke took over; the complete elimination of the term premium is unprecedented in Macro Man's lifetime. For this, we probably have to thank Voldemort and other price insensitive Treasury buyers have have generated a structural flattening of the curve.
The second thing that struck your humble scribe is that just four months into his first easing campaign, Mr. Bernanke has managed to engineer a lower real 10 year rate than "Easy Alan" Greenspan ever accomplished in 19 years at the helm of the Fed. It just goes to show that while you can take Ben out of the helicpoter, you can't take the helicopter out of Ben.
To Macro Man, the implication is that the dollar should continue to trade poorly and that inflation remains the most likely outcome. As he has observed in the past, Mr. Bernanke appears to be pursuing a 1970's solution to a 21st century problem. The upshot is that if the market does try to take 2 year note yields to all time lows, it could ultimately represent the shorting opportunity of a lifetime.
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January 23, 2008 at 11:47 AM ×

M,

It's a little disorienting when the biggest market is closed on a day like Monday. In this case, the US chose to blythely ignore, today being the first day of the rest of our lives (apparently), and took its lead from the European Tuesday instead. Despite the recent events, I cannot get it out of my head that there remains a tremendous amount of complacency in the mix.

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Macro Man
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January 23, 2008 at 12:51 PM ×

Hmm, I dunno CB; did that thing you sent last night look like complacency? (For the benefit of those reading these comments, it was a 7 minute video of a US retail trader watching the market on his Sunday night, complete with real time P/L.

Suffice to say that he did not watch the erosion of his eprsonal wealth with equanimity; every other word he uttered began with "F" and rhymed with "duck", "clucked", "bucking", or, pershap most poignantly, "sucker."

Alas, the video has been removed from youtube, perhaps because of the industrial language.)

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January 23, 2008 at 1:23 PM ×

He may not be now, penniless as he is, but he sure was hummingly complacent when he dived into the gap. We'll change the word though. Make 'complacency', 'underestimation'.

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Macro Man
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January 23, 2008 at 1:24 PM ×

'Tis a pity he's been yanked. He could well have become the R-rated poster child for the new bear market, if that is indeed what we are in.

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January 23, 2008 at 1:34 PM ×

It's taking a while to dawn on equities markets the notion that if you don't know what the risk is, better to consider it unlimited. Haven't heard the word 'sygma' for a while, have we?

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Macro Man
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January 23, 2008 at 1:42 PM ×

Not in common parlance, though those in the know are obviously aware. Meanwhile, I'm just wondering if I will be stopped out of my cheeky call option trade before I have a chance to execute it!

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ECB
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January 23, 2008 at 1:44 PM ×

Trichet reminds me of James Baker the weekend before the Crash of 1987 ...... the coming meltdown of the European banks will give Citibank lots of company.... stay short all European financials

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Macro Man
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January 23, 2008 at 1:46 PM ×

What I find hilarious is that the rumoured losses at BNP and SocGen are being reported in French francs....when the young bucks who no doubt bought all the crap causing the losses probably can barely remember what a FRF is...

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Anonymous
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January 23, 2008 at 2:09 PM ×

MM,
while I agree broadly with what you wrote, I would still like to point out that real short and long rates moving in tandem is to a significant degree the effect of relatively large changes in headline inflation (I assume that's what you use) in a world of pretty low nominal interest rates.

Bureaucrat

PS The panic button picture was brilliant.

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Quarrel
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January 23, 2008 at 2:50 PM ×

The video is still available - second item down (as I write this) at the source:

High Probability Blog

Some of my equity positions felt a bit like that :(

Luckily I'm not looking to my profits on them to eat - which it seemed might be closer to the truth for this poor fellow.


--Q

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Macro Man
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January 23, 2008 at 2:57 PM ×

Quarrel, you're a star, thanks. If anything, his web site is more- I don't even now what adjective to use here- than just the video.

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Peter
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January 23, 2008 at 3:00 PM ×

too much bear talk for not to have a bounce..

unfortunately i thought the same on thursday already.. seems like an eternity and many many p&l dollars away..

cats have 9 lives (or 7, cant remember). dont know about traders, but i surely used up 3 in the last 6 months..

good luck

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January 23, 2008 at 3:26 PM ×

Q,

The HP Blog is priceless. Thanks.

Sorry MM, I'm moving on to greener pastures...

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Macro Man
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January 23, 2008 at 4:26 PM ×

Bureaucrat, CPI is taken away from both series, so the chart would look the same (albeit with a different scale)if it were nominal rates. The point I was making is that the closeness of the recent link between FF and 10's in terms of both direction and level appears to be relatively unprecedented.

Peter, my foray into dip buying was on a paltry amount of options struck nearly 100 SPX points away. Tells you how confident I am in that trade...

CB, understood. The HP website takes public angst to a whole new level...

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Anonymous
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January 23, 2008 at 4:32 PM ×

does the fact that the Dow Transp. Index is so far up mean anything .. ? is that to be taken seriously, or its just superstition ?

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Macro Man
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January 23, 2008 at 4:40 PM ×

Classic Dow theory suggest that the Transports are significant...but then again, classic Dow theory was created when railroads were a) the only feasible way to cross the US, and b) a MUCH more important sector relative to the overall size of the market than they are now.

I'd propose the Nasdaq as a latter day equivlanet.

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Anonymous
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January 23, 2008 at 4:52 PM ×

so its superstition..

thanks MM !

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Gregor
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January 23, 2008 at 6:39 PM ×

The railroads are a play on oil depletion. Or, put another way, a play on structurally higher oil prices. I expect them to reassert themselves in the DTX, pushing the truckers out to the edges. Long-haul trucking has no future, and neither does air transport for all but the elite. The bottom line is that the rails are going to surprise to the upside over the next 3 years. I would suggest the book Train Time by John Stilgoe at Harvard, and his other writings. The US and Canadian rails are also a play on coal and grains exports. And believe me, the USA is going to have to ship a ton of coal and grains in the years ahead as we get reacquainted with the old-fashioned idea of "production."

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Gregor
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January 23, 2008 at 6:55 PM ×

My comment on the Trichet hissy fit: we've got a bunch of folks over here in the US trying to put the Scholar's Spin on this, saying he remembers the Alamo (excuse me, the hyperinflation of the 1930's). The thesis is Jean Paul Belmondo (sorry again, Jean-Claude) is constitutionally unable to cut.

I disagree and I think his tantrum earlier today is the set up, for the cut.

Kinda reminds me of Ben's war of words on inflation in Summer of 2006, just before he paused.

I think a central banker is programmed to scream about Temperance, as his friends cart him off to the pub.

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CV
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January 23, 2008 at 9:24 PM ×

Oh my god,

That video is just painful to watch ... Really, I feel sorry for the poor guy.

Claus

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Quarrel
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January 24, 2008 at 1:01 AM ×

MM,

now you know what passes for insightful commentary in the blogosphere, I'm hoping we get to see videos of you screaming at your Bloomberg terminal.

Today could have seen you exhorting the S&P500 to recover as it plummets towards your stop only to have it respond and fly up proving your genius to us all. :)


--Q

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Bureaucrat
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January 24, 2008 at 10:39 AM ×

MM,
I obviously understand that CPI is taken away from both series, but the charts still wouldn't look the same if they were nominal. The point is that there has been a lot of volatility in inflation recently, hence at a time where nominal rates are quite low, a lot of the co-movement that you see in the picture for recent years is likely not driven by (relatively small) changes in interest rates, but rather by (relatively large) changes in inflation. Sorry for not being clearer the first time.

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Yaser Anwar
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January 26, 2008 at 6:05 PM ×

MM-

Thank you for the post. By shorting opportunity of a life time you mean shorting the 2 yrs when the Fed is done cutting right (and yield starts rising after 6 or so months)?

Thank you.

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Macro Man
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January 26, 2008 at 7:00 PM ×

Yaser, basically, yes.

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