Market Insider

Published: Friday, 5 Jun 2009 | 8:35 PM ET

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The stock market's rally could face a critical test in the coming week as the "recovery trade" plays out across financial markets.

As market dynamics shift, rising Treasury rates are worrying stock investors, who fear they could slow a recovery and dampen the market's rally.

The S&P 500 rose 2.3 percent to 940 in the past week, giving it 11 winning weeks out of the past 13. The Dow climbed 262, or 3 percent, to 8763.

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The stock market has been rising for weeks now on the theory that improving economic data means recovery is on the horizon. Yet, its response to Friday's better-than-expected jobs report was tepid. The highly-anticipated May employment data did send mixed signals to the markets, as the unemployment rate rose sharply, to 9.4 percent but job losses were way less than expected.

But the promise of economic recovery in the improving payrolls number drove buyers into the dollar and sellers into Treasurys. The shorter duration Treasurys were particularly hit, resulting in a sudden and dramatic flattening of the yield curve and a quick move up in rates in the 2-year note. The 2-year yield climbed to 1.307 percent, it highest rate since Nov. 7.

At the same time, oil, which briefly crossed $70 per barrel Friday, held gains as most commodities weakened. Oil finished the week 3.2 percent higher at $68.44 per barrel. Traders are particularly watching commodities to see if they continue to move higher on the idea that the global economy is improving, but also for fear they are signaling rising inflation.

Oliver P. Quilla for CNBC.com New York Stock Exchange

Commodities have been trading opposite in direction to the dollar. But after Friday's about face by the green back, some traders speculated there could be a disconnect between commodities and the dollar, and both could strengthen on the idea that the U.S. economy will be first to recover.

Traders say these cross market trends are important for the week ahead, when there is some key economic data and the auction of about $65 billion in 3-, 10- and 30-year notes. Treasurys have been volatile, and rising yields have been attributed both to an improving economy and supply concerns as a huge amount of Treasury issuance continues to come to market.

In Friday's markets, traders said there was speculation the Fed could soon be raising interest rates if the economy is recovering. "People are trying to get way ahead of whether the Fed is going to try to raise rates. I think that's very premature. The economic news is better than expected, but it shouldn't make anyone all that excited," said Brian Edmonds, head of interest rate trading at Cantor, Fitzgerald. Edmonds expects the bond market to drift higher in the coming week, which would push rates lower.

Kevin Ferry of Cronus Futures Management said the Treasury auctions could be influenced by the stock market's performance. "Structurally, the only reason the auctions would do well is if now yields have risen enough...which way the stock market goes at the end of the day is important. They've both got to compete for domestic dollars," he said.

Whither Stocks

BlackRock Vice Chairman Robert Doll says stocks remain positioned to move higher, as fresh cash continues to come into the market every time there is a dip.

"The market's behaving much better than I thought it would. I would have thought we'd have a pull back of note. I'm still sticking with the 1,000 S&P (year end) target we had since the beginning of the year," Doll said in a phone interview. "I still think we might see 800 to 850 before we see 1,000.

But "there's so much cash on the sidelines that in any kind of pull back, people are waiting to put some money in," said Doll.

Doll said one trend that bothers him is the market leadership of lower quality stocks. He notes that while for the first 60 days of the rally, from March 6 to May 6, the S&P 500 was up 38 percent. Yet, the lowest quality decile of names in the index was up 145 percent, and the highest quality rose only 22 percent.

"Can the market keep going up on the back of low quality companies? My feeling is 'no.' Either the market broadens to high quality names or we need to have a correction," he said.

Many of those "low quality" names were S&P 500 stocks that sold in the single digits after February's drubbing. At one point, about 20 percent of the S&P were trading at single digit levels.

"The point we are making is we are slowly upgrading the quality of the portfolio...Companies with good free cash flow and strong balance sheets which come out of a whole variety of sectors. Some are in health care, tech and some consumer names, as opposed to some of the deeper cyclicals and financials," Doll said. He said half the companies in the lowest quality tier of the S and P are financials.

Doll said he is not concerned about the move in Treasury yields. "My thesis is the backup in rates we've seen in the last couple of weeks is all about normalization of rates. It's about deflation is less of a concern than it was. Rates were too low," said Doll.

He, like others, is worried about the government's programs and said the markets need to see an exist strategy.

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"We are spending money to get us out of the mess, but there's a limit to everything. We're just spending like drunken sailors. We have to understand these problems are temporary and we're going to pull back at some point. That's part of the interest rates concern and dollar story," said Doll.

Treasury traders mention that concern daily. "I think now the country's mood is going to be if we can't afford to do all this, and we're watching rates spike higher then let's cut back on what we're trying to do right now. I think the markets have told (Fed Chairman Ben) Bernanke and anyone else who is paying attention that the U.S. can't have uncontrolled deficits," said Edmonds.

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