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Will Yellen take the chill off markets?

Nicholas Eveleigh | Getty Images

Traders across the financial markets will be hyper-focused on Congressional testimony from Fed Chair Janet Yellen Wednesday to see if she has a message that could alter the course for interest rates.

Yields at the long end of the Treasury curve have been falling, taking the dollar lower and making stocks nervous. The move has perplexed traders and strategists, who pin it on a variety of factors. They range from repositioning by investors who became too short bonds; central bank and pension fund buying; relative value to other sovereigns; worries about the economy; and even the sense that the stock market is overvalued.

The 10-year yield Tuesday was at 2.59, close to the bottom of a range its been in since January. Traders will be watching the 1 p.m. auction of $24 billion 10-year notes to see if the market needs to make a concession to attract buyers.

Stocks got smoked Tuesday, with the Nasdaq and small cap Russell 2000 leading the decline. Twitter was off nearly 18 percent at an all-time low, as stock lockups that prevented insiders from selling expired. Other momentum names went down with int including Yelp, Priceline.com, Facebook and LinkedIn.

The Dow was off 129 points at 16,401, and the S&P 500 was off 16 points at 1,867. The Nasdaq was down 1.4 percent at 4,080, and the Russell 2000 fell 1.6 percent to 1,108, closing below its 200-day moving average.

"The market's clearly topping out, and we just have to watch and see if this is temporary, or something deeper," said Peter Boockvar, chief market analyst at Lindsey Group. He said it will be important to see whether the S&P and the Dow follow the Russell below their 200-day moving averages.

"Whether we see buyers on the dip will be a key tell on the state of risk taking. One day is not necessarily a big deal. It's noteworthy that this is the first time it's happened since November, 2012."

Boockvar said he does not expect Yellen to make news Wednesday, but he is watching the release of productivity and costs at 8:30 a.m. to see if there is a move higher in labor costs. He's also watching the bond market, which he says is warning of possible economic slowing as the Fed winds down its quantitative easing bond buying program.

"If you're an equity investor, you have no choice but to scratch your head when you see what's going on in yields," Boockvar said.

Bears are also circling the dollar, and the greenback could stay trapped in a lower range until U.S. rates bottom and move higher.

The dollar index sank nearly a half percent Tuesday and is now down nearly a full percent in the last week.The dollar was weaker across the board—falling against the euro, yen, sterling, Swiss franc and major emerging market currencies such as the Indian rupee and Turkish lira.

The dollar index was at its lowest level since October 2012, and its lowest level against the pound since August 2009. The dollar index was at 79.18 in late afternoon trading.

"What's wrong with the dollar? I'd say there's better places to put your money," said Brown Brothers Harriman chief currency strategist Marc Chandler, noting the U.K. economy is getting stronger and the Bank of England is likely to move sooner than the Fed to hike rates.

Even though the U.S. economy is stronger than the euro zone and Europe is more exposed to potential fallout from Ukraine, the euro was heading toward $1.40. At the same time, buyers drove the yields on 10-year Spanish and Italian bonds to all-time lows below 3 percent. The German 10-year bund, yielding 1.45 percent, was close to its widest spread against the U.S. 10-year in more than nine years.

Read MoreWhat's really scaring stock traders

"I think people realize the ECB (European Central Bank) is unlikely to do anything on Thursday. The stronger data argues against them doing anything," Chandler said. Ahead of Thursday's ECB rate setting meeting, the euro was at its highest level since mid-March.

That puts the focus on the Fed, which has been tapering its bond buying program but still purchasing $45 billion per month. It also puts the spotlight on Fed Chair Janet Yellen who goes to Capitol Hill on Wednesday at 10 a.m. to testify before the Joint Economic Committee and Thursday before the Senate Budget Committee.

"I think she'll try to keep a dovish tone in general. I think to the extent she realizes there's been a bounce back in labor market activity, and activity in general, [that's] going to be important," said Alan Ruskin, head of G-10 currency strategy at Deutsche Bank. "I think she'll take the FOMC line and there's desire on her part to stay under the radar."

Strategists said Yellen's comments on the labor market are especially important since the metrics she watches were disappointing in the April employment report, while the number of jobs created was a strong 288,000.

There was a sharp drop in the unemployment rate to 6.3 percent, though the level was affected by a steep drop in the participation rate. There was also no gain in average hourly wages and the number of people working part-time for economic reasons increased.

"That's what she's been focusing on, not the unemployment rate. These measures deteriorated which is why I think bonds rallied, and we're still for all practical reasons at the low end of the bond yield range," Chandler said.

Read MoreGundlach: Odds rising that yields will reach 2012 lows

Ruskin said the markets will still be listening for any suggestion of a time frame on Fed tightening, even though Fed officials and Yellen herself have backed off her comment in March that the Fed could begin hiking rates six months after tapering ends.

"There's still some debate about that. Did she mean it? Was it a slip? Was it intentional? Just as important, was it unintentional?" asked Ruskin, noting markets will be looking for any clue as to the gap between the end of bond buying and the start of a rate-hike cycle.

Ruskin said he expects the dollar to recover when there's sign of inflation or a further dip in the unemployment rate.

"You need the interest rate market to take the thoughts of tightening seriously," he said. "I think you need the expectations of Fed tightening being brought forward. You need the markets to take a much less dovish line."

Robert Sinche, chief global currency strategist at Pierpont Securities, said he thinks the dollar will turn higher and end the year well off its lows, while the euro should dip back to the 1.30 level.

"It's rates, rates, rates," he said. The dollar has been sliding with yields. The 10-year was trading at its lows of the year this week, under 2.60 percent, and has moved lower from 3 percent at the beginning of the year.

Strategists say part of the buying is the result of a massive short in the market, created when investors bet wrong that rates would rise this year.

"I think we're in the bottoming process, and a lot of it will depend on whether—as I think—the data is improving. I think what I'm most worried about is have we covered the short position. That could give us another squeeze lower in the dollar," Sinche said.

What Else to Watch

Bank of America holds its annual meeting at 10 a.m. in Charlotte, N.C.

Earnings are expected before the bell from Allergan, Mondelez, Siemens, A-B Inbev, Molson Coors, Nintendo, Hertz Global, Icahn Enterprises, Sotheby's and AOL. Companies reporting after the close include Tesla, Caesars Entertainment, Sprout's Farmers Market and Zillow.

By CNBC's Patti Domm

  • 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.

  • CNBC Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.