As earnings season kicks off in the coming week, traders will be keeping one eye on the bond market, wary that rising rates could sting stocks.
Alcoa reports Monday, and JPMorgan and Wells Fargo report Friday, in the first trickle of second-quarter releases. There are also a number of economic reports, including inflation data and consumer sentiment. Minutes of the last Fed meeting are released Wednesday, and Fed Chairman Ben Bernanke speaks after the market close that day to the National Bureau of Economic Research conference.
"I think earnings start to come back in the forefront next week, and I think the earnings season looks a lot like Q1 earnings season to me, where expectations were marked down a lot," said Andrew Burkly, Oppenheimer Asset Management's head of institutional portfolio strategy. "The expectations that we're looking at 1 percent earnings growth and 1 percent revenue growth."
Burkly expects earnings growth to come in several percent better than expected, as it has in recent quarters, but said revenues are likely to stay flattish.
So far, earnings pre-announcements have been extremely negative. Through last Friday, Thomson Reuters says the ratio of negative to positive comments is 6.5 to 1, more than 2 1/2 times the normal pace and the most negative reading since 2001.
"We're a little more optimistic than the consensus right now, but any way you slice it, it's not going to be a good earnings season," said BTIG chief global strategist Daniel Greenhaus. "Guidance is particularly important since you're going to have much less Fed accommodation."
The quantitative easing program has been credited with helping push stocks higher, and the Fed has said it would start winding down the $85 billion-a-month bond-purchasing program by year-end. Friday's stronger-than-expected June jobs report has many traders now expecting the Fed to begin reducing its bond purchases as early as September. A snap CNBC Fed survey of economists, fund managers and strategists showed that a clear majority now expect the central bank to begin tapering in September or October with an average reduction of $22 billion.
The stock market also will be watching the bond market in the week ahead, after yields moved sharply higher after the employment report. Nonfarm payrolls were 195,000, and the unemployment rate was 7.6 percent. Jobs came in 30,000 better than expected, and an additional 70,000 in revisions for April and May took the six month average to 202,000.
"If job growth is 200,000, that would signal the end of QE and the beginning of rate hikes could be sooner than the time associated by the market," said Mark Zandi, chief economist at Moody's Analytics.
Zandi said the employment report was also strong enough to suggest the Fed could begin to raise short-term interest rates by spring 2015, several months sooner than expected. While the unemployment rate of 7.5 percent did not change, Zandi said unemployment could come down a bit sooner than the Fed expects. The Fed has targeted an unemployment rate of 6.5 percent as a trigger to begin to move the Fed funds target rate, now at zero.
Markets will continue to adjust to this dynamic in the coming week, and the reaction to three bond auctions should be telling. The Treasury is auctioning $32 billion in three-year notes Tuesday, $21 billion reopened 10-year notes Wednesday and $13 billion reopened 30-year bonds Thursday.
"One thing we're going to look at is how the market trades in here," said David Ader, chief Treasury strategist at CRT Capital. Rising U.S. rates have pushed the dollar to a three-year high against a basket of currencies Friday and has sent emerging markets reeling. Brazil's Bovespa, for instance, was down nearly 6 percent in the past week.
The upcoming auctions will be offset by the Fed's Treasury purchases, he said.
"It's going to be a good test, but the market's going to stay on the back foot and the curve is going to steepen because we're going to see a bunch of buy backs," Ader said. "There's a good chance we'll see 2.75 [percent 10-year yield]."
U.S. stocks managed to score big gains Friday, even as the 10-year yield rose to 2.73 percent, its highest level since August 2011. Stocks sold off early but ended the day up 1 percent, even as rates continued to rise.
The S&P 500 finished the week at 1,631, up 1.6 percent, and the Dow ended at 15,135 , a gain of 1.5 percent. In a bullish sign, the S&P managed Friday to break above its 50-day moving average of 1,626 after testing it for several days.
Scott Redler of T3Live.com, who watches the market's short-term technical moves, said stocks' performance was impressive given the move in yields.
"It's constructive to see that they held firm and leaders acted well," he said, adding that it was understandably not a powerful move, given the short week and thin market.
"Markets proved equities can go up with yields moving higher—a welcome sight," Redler said. "Every threshold in yields will bring some anxiety. Equities have a positive tone, and markets are starting to prove that last week's bounce back was more than window-dressing. Stock selection is still key, and the Russell is leading the way," he said. The Russell 2000 was up 1 percent at 972, a new high.
The dollar index was up more than 1.5 percent in the past week and could continue to be supported by higher U.S. rates. It is also likely to stay firm against the euro after moves by central banks in the past week.
On the July 4 holiday, both the European Central Bank and Bank of England held regular rates meetings. With more bluntness than normal, they both emphasized that there would be no policy changes and that rates would stay low. That sent equity markets sharply higher and bond yields lower Thursday. At the same time, Portugal, which had worried the markets, managed to keep its coalition government together.
European markets gave up some of those gains Friday, but the tension of easier European monetary policy versus expected tightening in the U.S. weighed on the euro and should provide support for the dollar.
(Read More: Why Europe Should Fear 'Turning Japanese')
In the coming week, ECB President Mario Draghi testifies at the European Parliament in Brussels on Monday, and there is also a Eurogroup meeting that day, ahead of Tuesday's ECOFIN meeting. The euro zone finance ministers are expected to decide whether to approve the latest 8 billion euro tranche of bailout funding for Greece.
Burkly said that with yields and the dollar rising, commodities should continue to falter. Crude, however, has been surging on political uncertainty in Egypt, where the military facilitated the removal of President Mohammed Morsi and protests continue. WTI crude, above $103, was up nearly 7 percent in the past week in its biggest weekly gain since October 2011.
'Taper' Talk Tensions
Economic data will continue to be important in the coming week, as traders monitor progress of other measures of job growth. One such report will be the Treasury's job openings and layoffs report Tuesday.
The stock market's base case seems to be that the economy will continue to build momentum and the Fed will taper its bond buying, Burkly said. But he sees it differently.
"When the Fed first started talking about tapering a few months ago, the economic data was still softening. We thought it wasn't going to happen because the data was still on the weak side," he said. "What we got at the end of the second quarter, the big three reports were ISM, above 50, auto sales were close to 16 million and the unemployment report is pretty strong. You have to say we ended on a pretty good note, but I would not say this is breakaway levels."
His concern is that equity values are already close to record highs, Burkly said. In a still soft economy, stocks can't continue to rise with rising rates, and a correction would not be a surprise.
"The debate is going to go on here, but I just don't think the economy is clearly strong enough, where it's a one-way direction, and I think the equity market is going to continue to be concerned about the Fed leaving too early, and I think that's a valid concern," he said.
Also a concern is that rates will rise so much that economic activity is hampered, particularly in the housing sector. Zandi said a 10-year yield of 2.75 percent sends mortgage rates closer to 5 percent for a 30-year conventional mortgage.
"That would suck the wind out of refinancings, but it may not hurt sales because it will get fence sitters to move" ahead of higher rates, he said.
What to Watch
3:00 p.m.: Consumer credit
7:30 a.m.: NFIB small business survey
10:00 a.m.: JOLTS survey
1:00 p.m.: Three-year auction
Earnings: Chevron (interim), Yum Brands, Family Dollar
10:00 a.m.: Wholesale trade
1:00 p.m.: 10-year-note auction
2:00 p.m.: FOMC minutes
4:10 p.m.: Fed Chairman Ben Bernanke speaks at NBER conference on a century of central banking, Q&A
8:30 a.m.: Initial claims
8:30 a.m.: Import prices
11:00 a.m.: Fed Gov. Daniel Tarullo testifies before Senate Banking Committee
1:00 p.m.: 30-year bond auction
2:00 p.m.: Federal budget
Earnings: JPMorgan, Wells Fargo
8:30 a.m.: PPI
9:55 a.m.: Consumer sentiment
—By Patti Domm, CNBC executive news editor. Follow her on Twitter