Dollar and bond yields to dominate trading

Dollar strength and bond yields, in the context of Federal Reserve tightening, will continue to dominate market movements on Wednesday.

"We had the market in a tight trading range, but now you see the market fixating on comments out of (Fed Chair Janet) Yellen and fixating on Europe," said Quincy Krosby, market strategist at Prudential Financial. "When the market wants to move higher it will. … We'll be following the dollar. That will be important to see whether or not it gains momentum."

The dollar rose 1.3 percent on Tuesday, up 2.6 percent month to date, as stronger U.S. data and indications of an interest rate hike boosted the greenback against major world currencies. The dollar reached its highest level against the yen since July 2007, while the euro fell below $1.09 for the first time since April 28.


Traders work on the floor of the New York Stock Exchange.
Getty Images
Traders work on the floor of the New York Stock Exchange.

Stocks sold off more than 1 percent on Tuesday, under pressure from strength in the dollar and better housing data that renewed anxiety over imminent central bank tightening.

Read MoreEl-Erian: Correction in stocks could happen if …

"The stock market is really a knee-jerk reaction to the Fed," said Jack Ablin, chief investment officer of BMO Private Bank. He said investors will continue to focus on when the Federal Reserve will raise rates and the situation in Greece.

That nation faces a 300 million euro ($326 million) payment deadline to the International Monetary Fund on June 5, the first of four payments due that month to the organization that total 1.6 billion euros. On Tuesday, both Greek and European officials attempted to calm fears that Athens would default on the payment.

"When there's a vacuum the market headlines become very important," Krosby said. "The Greece headlines become very important because there's nothing (else) to focus on."

Read MoreDisciplinary actions: See which firms made the list

The S&P 500 closed down 1 percent for its worst day since May 5. The index did hold the key 2,100 level that JJ Kinahan, chief strategist at TD Ameritrade, was watching.

The Dow Jones Industrial average had its poorest performance of the month, dropping 190 points to close at 18,041. The Nasdaq also had its worst day since May 5, falling 1.11 percent as tech stocks led by a 2.2 percent decline in Apple weighed on the index.

Analysts said the massive selloff could result in a bounce back on Wednesday, bringing volatility back into focus.

Read MoreThis is giving a sense of a major top: Jim Paulsen

The CBOE Volatility Index, considered the best gauge of fear in the market, spiked 16 percent on Tuesday to 14.06 after dipping below 12 for the first time in six months on Friday.

Against "the backdrop of what's going on globally and the question of when rates are going to rise in the United States ... if you see the VIX continue to go up at these levels then you'll see significant correction pricing in," said Andrew W. Ferraro, wealth advisor at Strategic Wealth Partners.

To be sure, the VIX is still at relatively low levels, trading below 15, Kinahan said. "People aren't necessarily buying volatility protection until needed," he said.

He said a factor in the stock selloff and the decline in longer-term bond yields may be traders rotating assets out of equities into the longer end of the Treasury market where yields are more attractive.

Read MoreConsumer confidence inches up in May

The U.S. 10-year Treasury yield fell to 2.14 percent in late trading Tuesday. The two-year yield dropped to 0.61 percent.

"The front end is holding up in response to decent economic data today as well as recent comments from the Fed restating their desire for a rate hike in 2015," said Brandon Swensen, co-head of U.S. fixed income at RBC Global Asset Management (U.S.). "The safe-haven bid for Treasurys remains as strong as ever, which is why they are always dangerous to short. Sentiment can turn quickly."

After a slew of economic data on Tuesday and ahead of Friday's GDP report, Wednesday is relatively quiet with only weekly mortgage applications due.

Tiffany, DSW and Costco report earnings before the bell on Wednesday and may shed further light on the retail environment. Luxury home builder Toll Brothers also posts results before the bell.