Nice bounce but will the bond market follow?

At 10:30 today, it was still unclear whether the markets would hold onto their gains or if Bears would take view it as a selling opportunity. The VIX, commonly known as the fear index but in reality a measure of market volatility, was still holding its own, only a few points off its all time high, leading one options trader, Think or Swim’s Joe Kinahan to comment: “The VIX isn’t down as much as you would think it might be. People are still cautious to short volatility.”

By noon, they’d thrown caution to the wind. As the market rallied — the S&P 500 closed up 104.1 points, the largest one-day point move in its history — the VIX dropped… and dropped… and dropped. It finished the day down nearly 15 points to close at 54.99. Joining it were gold, which fell for the third day in a row to close at $838.90. Even LIBOR, the rate banks would charge each other if they were, in fact, lending fell .07%, the largest drop since mid-March. All in all, a spectacular day for the bulls.

Now the real work starts. The S&P’s enormous gain today only made up for last week’s drop. The VIX, too, is well above normal levels — its average for the last 12-months is 24.75, less than half of today’s closing price. Despite today’s drop, LIBOR is still high. Just one month ago, the 3-month Libor was 2.82%.

The real test comes tomorrow. Because of Columbus Day, US bond markets had the day off, so bond traders were unable to join the rally. If there’s a sell-off in Treasury’s, as investors pursue other bonds, the TED Spread, the difference between LIBOR and Treasuries should narrow.

But the real impact won’t be known for days or even weeks. LIBOR needs to drop more than 7 basis points. Banks need to start lending again. If they do, the rally could be the start of something big. If not, it’s just an opportunity to get short on the way to DOW 7000.