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Market Insider: Thursday Look Ahead

Mortgage rates are already falling as a result of the Fed's plan to add another trillion dollars of fire power to its arsenal, but traders worry the move is a poor statement on the economy.

The Fed Wednesday surprised markets with a plan to buy up to $300 billion in Treasurysand boost the size of programs aimed at reducing mortgage rates by $750 billion.

The announcement triggered a dramatic move down in Treasury yields as bonds surged. The dollar fell, and stocks moved higher. The U.S. joins Britain and Japan in programs to buy government debt.

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If history is a guide, stocks should trade lower off the open Thursday. "We do see that morning after reaction pretty consistently after Fed meetings," said Art Hogan, managing director at Jefferies.

"It's kind of celebrating the fact that the doctor got here very quickly," he said. "The next day, instead of having the reaction that you got the really strong medicine, you're reacting to the idea that you needed the really strong medicine."

Markets will continue to digest the Fed news Thursday as well as the launch of the Fed's Term Asset-Backed Securities Loan Facility, or TALF, aimed at consumer loans. There are also several economic indicators, including weekly jobless claims at 8:30 a.m. Leading indicators and the Philadelphia Fed index are reported at 10 a.m.

Traders are also watching General Electric's investor meeting on its GE Capital unit, which starts at 9 a.m. and is expected to be a deep look at the finance unit's holdings. FedEx reports earnings ahead of the bell, and Palm reports after the close.

The Dow Wednesday rose 90, or 1.2 percent to 7486, while the S&P 500 climbed 15 or 2 percent to 794. The Nasdaq was up 29 or about 2 percent to 1491. The financial sector jumped 10 percent. The next best sector was consumer discretionary, up 3.2 percent. The defensive consumer staple sector was the worst performer, off a half percent.

"The market liked the news. I do think the Fed here has moved one step ahead of other policy makers, and I think that's important. They were kind of lagging in the past month or so. The fact they are on the vanguard is important. Buying the Treasurys is important. That's the lynch pin for the mortgage rate," said Greg Peters, head of global head of fixed income research at Morgan Stanley.

Traders say the Fed's action is an aggressive stab at the mortgage market that will likely see results. A 30-year fixed mortgage was quoted at 4.75 percent Wednesday. But a concern about the plan, and other programs, is that they will ultimately fuel inflation as the Fed basically prints money to make them work.

The yield on the 10-year meanwhile had its biggest one-day move since 1987. The yield, which was at 3.0 percent Tuesday, fell 47 basis points to 2.533 percent. The two year's yield fell to 0.826 percent, a decline of 21.10 basis points.

"It's a very bad day if you want to be technical for how the Fed actually believes this is their only course of action ... that they have to do this to get rates down, and the stock market only moves 90 points higher," said Michael Franzese, head of government bond trading at Standard Chartered. Franzese though had been expecting a dramatic Fed statement.

"The action that they took to double the Fed balance sheet ... Think about where we are. They're committed. They're in with both hands now. What if rates continue to creep up and mortgages don't come down to the level they want?" said Franzese. Will it work? "We'll know in a couple of weeks," he said.

The Fed's TALF program allows hedge funds and others to borrow from the Fed on favorable terms. The investors are then to use the cash to buy new securities that will aid the consumer finance market for auto loans, credit cards and other consumer financing. News reports Thursday indicated the Fed could use TALF for some distressed assets.

"TALF I think is eventually going to under whelm," said Peters. He also said the public private partnership program, expected from the Treasury in the next couple of days will also have issues and may have a harder time than expected attracting participants. The plan is expected to address the toxic assets on banks' books.

"What I'm hearing from a client perspective is nobody wants to be involved with the scrutiny and persecution. There's a real concern the government will retroactively change the rules," he said.

Peters said there's also a perceptual problem with programs that have been discussed in theory but without real details. "It's like a software company rolling out a version 3.0 when they haven't even launched a beta version," he said.

Getting Technical

Scott Redler of T3Live.com said he would normally expect the stock market to trade off after the Fed, but Thursday's market may react differently because there is also impact from Friday's expirations of options and futures. He said the current rally's fast move up is probably over, but the market could still trade higher before a likely retracement sets in next week. "Typically, there's a reversal the next day of what happened on Fed day, but then we have quadruple witching which could shake up the norm," he said.

"Our target was 795 to 810 (on the S&P) from when we started buying, but we didn't think it would happen within two weeks. The 795 to 810 level was the target where we expected to this powerful first leg up run into problems," he said. "At this point, even though the market can go higher, the risk reward is not in favor of initiating new positions right here."

Redler, who watches the market's short term moves, said he would reassess if the market pushes to 805 to 810.

After Hours

President Obama appears on the "Tonight Show" with Jay Leno Thursday night, in the first of two major TV interviews. He will also do an interview with "60 Minutes" Sunday, following last Sunday's appearance by Fed Chairman Ben Bernanke on the program.

Citigroup

Citigroup shares have rocketed 73 percent this week, trading up 23 percent to a level above $3 Wednesday. Traders blame a crowded arbitrage trade by hedge funds and others to capitalize on the conversion of the Citi preferred shares, held by the government and others, into common stock. The trade has been popular for some time but it has lost its appeal now that Citi stock is rising. Traders also have become nervous about what the actual conversion rate will be when Citi files its S4.

The stock has been especially hard to borrow for those who are shorting Citi common as part of the trade. The lack of shares available paralleled market rumors this week that the government was demanding investors who shorted the stock show proof they could borrow shares. Traders though say this is the result of an added vigilance by prime brokers on stocks that are part of the government's TARP program.

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"The arbitrage play is you buy the preferred. You short the common and you lock in the difference because you're going to get the common back to pay off your short. You can only do that if the security is available for the short position," said Hogan.

Alec Levine, options strategist at Saratoga Capital, wrote in a note Wednesday that an option strategy that mimicked the arbitrage strategy traded about a million times over the past week.

"You synthetically short it in the options market, and you offset that by buying the stock," he explained in an interview. "What this frees you up to do is to have long stock. You put on the conversion that'll give you long stock so now you can go out into the market place and buy the preferred, sell out you long stock and what you're left with is a synthetically short stock position through options and the long preferred." Levine said he is not recommending the trade.

"With the conversion priced here it is too risky to get involved especially since the S4 on the preferred convertible has not been released, the deal terms could be changed and people should respect this issue," he wrote.

Questions? Comments? marketinsider@cnbc.com
  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC Senior Commodities Correspondent and Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.