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Stock traders watching out for the sting from higher yields

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Already cranky about the Fed, stock traders will be eyeing the Treasury's 10-year note auction Wednesday to see whether it helps drive interest rates higher.

Stocks had their biggest fall since June Tuesday as talk focused on the Fed's plans to wind down its $85 billion a month in bond purchases. While there was not much new, comments by Chicago Fed President Charles Evans and Atlanta Fed President Dennis Lockhart helped sour the mood.

(Read more: US bond prices little changed amid supply)

Evans, a dovish member, said he wouldn't rule out that the Fed could begin to 'taper' its bond purchases starting in September. Lockhart said the Fed could start cutting back at any of the three remaining meetings this year, in an interview with MNI. Dallas Fed President Richard Fisher, had already started the hawkier talk Monday when he said the Fed could start in September.

"I think it's the reality of the Fed acting in September. I think the stock market has been completely ignoring this move in interest rates," said Peter Boockvar, chief market analyst at the Lindsay Group.

"The bond market to me has clearly priced in this taper and the stock market is in this Goldilocks phase. Easy money from the Fed is what got us here predominantly and the idea that we could deal with the taper with no problem was a little aggressive."

The Treasury auctions $24 billion 10-year notes at 1 p.m., following Tuesday's strong $32 billion 3-year note auction. Treasurys ended Tuesday barely changed, and the 10-year was yielding 2.65 percent.

(Read more: Fed may cut bond buying as soon as next month, Evans)

"So the dealer take was the lowest since August 2011 for a 3-year note. It was a pretty good auction," said John Briggs, senior Treasury strategist with RBS. "I think it's hard to take the good results of the 3-year and transition that to the 10-year. My view is if we can back up a little into the 10-year and 30-year auctions then things could go pretty well."

Briggs said if the 10-year yield moves higher into the auction, closer to the higher end of its recent range – at 2.7 percent or better - then it should be smooth sailing. He said he would then expect to see a firming in bond prices, after the 10-year auction Wednesday and the $16 billion 30-year auction Thursday. For the past 11 years, the Treasury market has rallied in the last two weeks of August, he noted.

"We're entering the dog days of August and that tends to benefit the Treasury market," Briggs said. "If (jobless) claims stay low and we get some decent data next week maybe that derails it."

(Read more: 'Most powerful bull market since World War II': Pro)

The positive news on trade Tuesday supported higher yields. The U.S. trade gap fell more than 22 percent during June, to $34.2 billion from $44.1 billion, prompting some economists to jack up their forecast for second quarter GDP to as much as 2.5 percent from the first reading of 1.7 percent.

The Dow fell 93 points to 15,518, and the S&P 500 fell 9 to 1697. The Nasdaq fell 27 to 3665. The Dow Transports and the Russell 2000 were the biggest losers. The Transports fell 1.3 percent to 6516, and the Russell lost 1 percent to 1052.

Art Cashin, director of floor operations at UBS, said stocks were sensitive to higher rates Tuesday though yields are not near the highs of last week. "I think the 10-year auction will be important. People will be watching that to get a sense of how things are going, to see how the bids fill in," he said.

(Read more: Surging US exports pare June trade gap)

"New money for the new month lasted two days," said Cashin.

Jack Ablin, CIO at BMO Private Bank, said he is not putting new money into U.S. big caps, and he would not be surprised to see a correction as the Fed reverses easing. As for now, "I think the market trades flat…I think that we're expecting some tapering, but we're not expecting liquidity to dry up unless we see something come over the transom that changes everyone's view – a wildly bullish or bearish jobs report, a failed auction, I don't know what. We have very low vol. There's a fair amount of complacency. Everyone is on vacation," he said.

But Ablin does think the market is extended, and it could see a 10 percent correction. "I'm more or less saying the safety net under this market is about 10 percent lower. If we were to remove the liquidity – the Fed were to pull the rug out from under the market, I'd say we'd get back to the 1570s which is 10 percent," he said.

What to watch

Besides the auction, there is more Fed speak including Cleveland Fed President Sandra Pianalto speaks at 1:40 p.m. on the regional economy in Cleveland, Ohio.

There is consumer credit at 3 p.m., and dozens of earnings reports. Time Warner,Ralph Lauren, AOL, Anglogold Ashanti, HollyFrontier, ING Group, Wendy's, Devon Energy, Marsh and McClennan, Duke Energy, and Carlyle Group report before the opening bell. Groupon, Green Mountain Coffee, Vale, Tesla Motors, Mondelez International, Sun Life, MBI, Jack in the Box, Diodes, Transociean, Prudential Financial, Westar Energy, American Water Works and Agrium report after the bell.

Updates to reflect that Philadelphia Fed President Charles Plosser is not speaking on the economy at 12:30 p.m. ET. His speech had been canceled Friday, according to a spokeswoman.

—By CNBC's Patti Domm. Follow here on Twitter @pattidomm.

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  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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