Interest rate worries hang over stocks

The bond market is starting to give the stock market agita, and focus could remain on interest rates Wednesday as traders try to handicap the Fed's next move.

A report from the San Francisco Fed staff, released Monday, injected an air of nervous into the Treasury market. The study said investors' expectations for rate hikes lag those of the Fed.

On top of that, the Treasury market has been full of talk that the Fed could tweak the language in its statement, removing a key phrase that has reassured markets it would hold rates lower for a long time to come.

Traders work on the floor of the New York Stock Exchange in New York.
Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange in New York.

The removal of the phrase that it expects to keep rates low for a "considerable" time is increasingly a topic of discussion in the market, particularly after comments from several Fed officials last week. While strategists don't agree on whether the central bank will change the language this month, or at a later meeting, they do agree the Fed has the potential to create confusion and volatility.

"By taking it out, you open up to a greater extent the probability of an earlier hike ... and that's the key," said Adrian Miller, fixed income strategist at GMP Securities.

The Fed is expected to wind down its quantitative easing program in the fall, announcing the final tapering of its bond buying in October. That has left the market guessing when it would move toward normalizing rates, and the first rate hike is widely expected in the middle of next year.

Read More A Fed phrase change could mean rates hikes sooner

"Where there's smoke, there's fire. There's some messaging that this is getting across," said George Goncalves, head of rate strategy at Nomura.

JPMorgan chief U.S. economist Michael Feroli, in a note, says there's a 50-50 chance of the language on "considerable" time being dropped. He pointed out that dovish Boston Fed President Eric Rosengren over the weekend echoed comments from hawkish Philadelphia Fed President Charles Plosser in opposing the date-based guidance and stressed that the Fed should instead focus on what incoming data is saying. Hawkish Cleveland Fed President Loretta Mester made a similar comment last week.

Read MoreFed to toughen surcharges for biggest banks

"The issue for the committee would be to move away from the calendar-based guidance of the 'considerable time' language without causing too much disruption or radical repricing of the Fed rate expectations," Feroli wrote, adding the Fed could counter that by emphasizing in the statement that its guidance does not indicate a change in policy intentions.

Goncalves said the market has already been moving ahead of the Fed, so if it did make a tweak the move will be less dramatic than it otherwise might have been.

"I'm just a little bit worried. They know the market's on pins and needles and hanging on every word they say. They know if they make it too drastic, it could backfire," said Goncalves. "At this juncture, I don't believe they want to be a source of volatility. That's the reason not to change the considerable period. That could mean they soften the language, but it still would mean they want to be on hold for a considerable time."

Goncalves said one of the arguments in favor of the central bank removing the language is the fact that Fed Chair Janet Yellen holds her quarterly press briefing next Wednesday, after the Fed releases it statement. She then could have an opportunity to explain any changes.

Miller said yields also moved higher Tuesday with European yields, which rose as the market sold off on concerns about how the European Central Bank will implement its recently announced asset purchase plan and worries that Scotland will vote to break from the United Kingdom.

Treasury yields rose, especially the five-year, the biggest loser on the day on a price basis.

Stocks on Tuesday saw their worst losses in five weeks, with the Dow off 0.6 percent at 17,013, and the S&P 500 fell 13, or 0.7 percent to 1,988.

Read MoreGundlach: Rates will remain stable through 2014

Scott Redler, partner at T3Live.com, said the market has a bearish feel.

"The S&P had the first close below its eight-day moving average for the first time since the rally ignited in August," he said, adding the S&P closed on its 21-day moving average of 1,988. "There's some signs momentum is leaving the market. ... The recent range has been trading 1,990 to 1,994. That's been the range we've been trying to close above and hold. Today we closed below it with a bearish feel."

Redler watches the market's short-term technicals. "Rates have been inching higher. ... Sometimes that gives the market a cue," he said.

What to Watch

Wholesale trade is announced at 10 a.m., and there is a $21 billion 10-year note auction at 1 p.m.

President Barack Obama speaks at 9 p.m. on the threat posed by Islamic terrorists in Iraq and Syria and how the U.S. will deal with the threat.

—By CNBC's Patti Domm