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Today is turning out to be a biggie in the rates space. We have kicked off with the European auctions and the results of of the Spanish and Greek Bills followed by the Irish results were as good as the ECB could hope for. Max Clifford is earning his bucks, but we were half wondering if Voldemort was about to jump out in a Leprechaun suit shouting "surplies!"

Once again, Fed Day is here and Team Macro Man are amazed, not just at how quickly it seems to have come around, but also just how much market expectations have changed since then - remember, it wasn't clear cut that they would reinvest their coupon proceeds, and this time around there is a reasonably large (though not necessarily "overly-large") chance of the full-blown QE2 sailing down the Potomac.

Since that meeting, the data has largely stabilized, Spooz are a good deal higher and Treasuries seem to be trading as if folks are a bit longer than they probably would like to be.

By contrast, the USD feels pretty offered (helped by Voldemort), and Gold has made new highs and looks somewhat overvalued relative to the rates space. Perhaps for good reason - TMM cannot conceive the Beard suddenly announcing:

I've been having a long think about things, especially after my holiday in Chiang Mai hanging out with Marc Faber, expanding my consciousness and think this QE thing should give way to a hard currency policy.

As far as Gold goes, TMM hold a lot of stock in the view that Gold is a Sovereign CDS view: when you can trust policymakers to run a bona fide inflation-targeting policy, it's a giant "yours," and this is why we have so much affection for our real rate chart (see below).

(Click to enlarge)

But in terms of expectations, TMM can't help thinking that the market has got itself into a similar position to last meeting, when hopes of a reflationary policy response were delivered, but an overnight reversal led many to throw the toys out of the pram and go on holiday (including most of the Team, itself).

The option markets seem to be expecting fireworks: 1-day Forward Option Agreements on the 10yr Note are pricing in a 14.5bp move, which would make today the biggest "event" day since 2008. In terms of Treasuries at least, that means QEII, an event where the 10yr yield falls say 25bps.

TMM believe that an "as expected," largely neutral statement and a slightly more dovish statement would produce +/-5bp moves respectively, while something more hawkish (e.g. - no real change in the outlook language) would probably result in a +10bp move.

Just looking at the events which would cause yields to fall (i.e. the circumstances under which the market expectation is for a -14.5bp move), we can come up with an estimate (usual caveats apply) for the market-based probability of QE: -14.5bps = -25*p[QEII]-5*p[dovish] = 25*p[QEII]-5*(1-P[QEII]), which throws out something like a 1 in 3 chance.

The FX options market is also pricing in significant event risk, with overnight EUR/USD Vol north of 21 (see second chart below), a level not seen since the May/June EMU crisis. Given that there doesn't appear to be an urgent need, at least from a data and financial conditions standpoint, for such a "shock and awe" measure, TMM is sceptical that the market is going to "enjoy" tonight, and for that reason will watch from the sidelines...

(Click to enlarge)

In another area, TMM's old favorite AUD/NZD looks to be at interesting levels. While the relentless positive chat from the central bank of "God's Country" has been driving Aussie rate expectations, and the drift down in the VIX have led quite a bit of support to the cross, macro players often forget that it is also a function of the Copper/Milk ratio. And with soft commodities looking like they're going to roof it, TMM reckons playing for a re-linking to this ratio might be worth a punt (see chart below, White - AUD/NZD, Orange - VIX, Green - Copper/Milk ratio, Pink - AU/NZ 2yr Rate Spread). There are also a veritable cauldron of soothsayer signals in AUS in general to suggest a turn, the strongest being in AUD/NZD.

(Click to enlarge)

All in all, it's going to be an interesting evening given that equities are eager to justify the technical breaks of yesterday. Whatever they do, they would be pretty damn dumb to do something to derail the optimism train just as it's looking like it's ready to pull out of the station. A demain...

Disclosure: No positions

Source: Europe's Action Packed Day: But Will It Be Enough for Equities to Justify Yesterday's Technical Breaks