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.