Thursday is round two in Yellen versus the bond market

Fed Chair Janet Yellen returns to Capitol Hill for a second day of testimony Thursday, and the bond market is likely to once more fight her every word.

As Yellen testified before the House Financial Services Committee on Wednesday, Treasury yields fell. The spread between 10-year and two-year yields moved to the flattest it's been since December 2007 — at 99.40 basis points. The market has been moving in this direction, and it continued to do so as some in the bond market were disappointed that Yellen did not say more about slowing rate hikes or even reversing them.

"I think she did a really good job of explaining the Fed's position, and I think it was somewhat calming from a market standpoint. But it didn't live up to some unrealistic expectations basically because she said we're heading toward rate normalization. Financial instability could slow the process but that's the track we're on," said Ward McCarthy, chief financial economist at Jefferies.

"She did not suggest the liftoff rate hike was responsible for this volatility and it's not. She did not suggest the Fed would backtrack in normalization or using the balance sheet. There were people who thought she was going to say we're the balance sheet of last resort for the universe. ... A lot of people's expectations were based on their positions and that's not the way the Fed operates — or she operates."

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Treasury yields closed lower Wednesday after the 1 p.m. ET $23 billion 10-year auction went well. Investors snapped up bonds even though yields are at the lowest level in months. The 10-year was auctioned at a high yield of 1.73 percent. Yellen testifies at 10 a.m. Thursday, and the Treasury holds another bond auction for 30-year bonds at 1 p.m.

"The Fed hasn't thrown in the towel. The bond market has. It doesn't believe them on interest rates," said Nomura's head rates strategist, George Goncalves. The Fed has been forecasting four rate hikes for this year, and the market hasn't even priced in a rate rise until June 2017. The central bank is widely expected to change its forecast and rate hike expectation when it meets March 15 and 16.

Benchmark 10-year notes ended Wednesday's session with a yield of 1.71 but continued to move lower in late trading, to 1.66 percent. The two-year also traded lower to 0.68 percent.

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"She's going to keep hanging onto that rudder and aiming for the North Star," said McCarthy. "The Fed has been telling a consistent story and acting appropriately. This is the era of permanent pessimism, and this has had an influence on expectations of what she was going to say today, which were not realistic. The Fed is trying to wean the market off constant support."

Goncalves said Yellen delivered what was expected. "She didn't want to sound overly dramatic about current events but she was acknowledging it. Plus they didn't take hikes completely off the table. They kept using the word gradual. This was not meant to be something to corroborate the recent price action in U.S. rates. It wasn't an explicit challenge but it was saying we understand markets are a little bit panicky ... but they're not necessarily willing to trash their outlook and they don't believe the rate markets are in the right spot."

Yellen also told the committee Wednesday that the Fed is not sure it could legally take rates negative as Europe and Japan have, and she also said it was unlikely the Fed would cut rates, having just raised them.

If you're bearish, it's wrong time to bail now: Pro
If you're bearish, it's wrong time to bail now: Pro   

"Negative rates is not something you should strive to achieve. It is a sign other things have not worked out," said Goncalves. He did say euro-dollar options are pricing in a very slight chance of negative U.S. yields, with a 5 percent chance for late 2016 and a 10 percent chance for early next year.

Goncalves said Treasury yields may be trying to find a bottom. "We're in this no man's land of trying to scrape the bottom and see how low it can go," he said.

"It's hard to call bottoms on anything. It was ironic that we're at levels we were at when the Fed was at full power twisting the curve, and the talk of the further QE as well as forward guidance. All that stuff was in the background, and Europe was in the headlines," said Goncalves.

The curve has been flattening as yields overseas fall, and U.S. Treasurys look more attractive than other sovereigns.

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A flattening yield curve can signal a recession, but analysts do not think that is necessarily what is happening now. "There's a lot of bad news priced in. We're discounting for some sort of event that we can't really place a finger on. What's going to be that event, and until we get to the absolute catalyst, it feels a little stretched," he said. "I think people will come to that conclusion. We need European rates to stop going down, and Japanese rates to stop going down. I get why people are flocking to our market, but these yields are too rich. There are a lot of people calling for a 1.5 percent 10-year."

McCarthy does not believe the flattening yield curve is the result of something very negative.

"By historical standards, the curve is still steeper than average. Second of all, what matters is why the yield curve is flattening. A flatter curve has preceded a recession or shows a deceleration in economic activity because short-term rates are rising faster than longer term. But now we have long-term rates falling faster than shorter-term rates. Flatter yield curves have been associated with rising rates and now we have one associated with falling rates and that's been driven by inflation expectations," he said.

Besides Yellen's 10 a.m. testimony, markets are watching for 8:30 a.m. initial weekly claims data. Pepsico, Total, Advance Auto Parts, Kellogg, Teva Pharma, TransCanada, GNC Holdings, Manchester United, Time Inc. and Nokia report earnings before the open. AIG, Activision Blizzard, CBS, KKR, Wynn Resorts, FireEye, Groupon, Zillow, Pandora and CyberArk Software report after the close.

Stocks closed mixed Wednesday after a volatile day. The S&P 500 fell 0.4 point to 1,851, and the Nasdaq rose 14 points to 4,283.

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