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Week Ahead: Expect Volatility as Fed Takes Away the Security Blanket

Uncertainties about the Greek debt situation and the removal of the security blanket of Fed easing could combine for another week of volatility, as the second quarter draws to an end.

Traders work on the floor of the New York Stock Exchange.
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Traders work on the floor of the New York Stock Exchange.

There is a busy economic calendar, including important ISM manufacturing data and three Treasury auctions totaling $99 billion in new securities, which hit the market next week just as the Fed's quantitative easing Treasury purchase program winds down.

Stocks in the past week were mixed, and the Dow and S&P 500 have now been lower for seven of the past eight weeks. The Dow lost 0.6 percent for the week to end at 11,934, while the S&P 500 was off 0.2 percent to 1268. The Nasdaq gained for the week, up 1.4 percent at 2652, and the Russell 2000was 2 percent higher at 797. June has not been kind to stocks. The S&P is down 5.7 percent for the month, down 4.3 percent for the quarter, but still holds a 0.9 percent gain for the year.

As stocks saw big swings, buyers piled into the Treasury market, sending yields across the curve to lows of the year this past week. The 10-year was at 2.84 percent Friday, and the 2-year was at 0.329 percent, their lowest levels since last November.

The dollar index gained nearly a percent for the week in a risk averse trade, and the euro slid 0.8 percent for the week to $1.41 by Friday, as investors watched the Greek government struggle with a confidence vote and an austerity plan it will vote on this coming Wednesday.

"I think that the combination of Europe concerns, quarter-end balance sheet constraints and just the volatility we were expecting the end of QE2 to bring, means a (bond) market that's not going to go down until we see July on the calendar," said John Briggs, senior Treasury strategist at RBS.

Stocks, however, could be under selling pressure for another couple of weeks, as investors watch Europe and also debt ceiling and budget discussions in the U.S. On Monday, President Barack Obama and Vice President Joe Biden will meet separately with the Democratic and Republican Senate leaders in an effort to get talks on the budget and long-term debt reduction on track.

Life Without QE2

Deutsche Bank chief U.S. equities strategist Binky Chadha said the stock market remains troubled by a number of concerns, including Europe, the U.S. debt debate, weak economic data and the end of the Fed's quantitative easing program, or QE2. He expects Greece to get its funding, and Congress to approve the increase in the debt ceiling.

"The two most important things (for stocks) are the macro and earnings. We start getting earnings when Alcoa reports on the eleventh of July. We need a little bit of comfort on the earnings front. They may not be settled irrefutably, but we should get quite a lot of clarity on all of these fronts by mid July. My expectation is that jobless claims start to move down in a much bigger way by mid-July. In terms of timing, (the stock market) should start to move in mid to late July," he said.

Chadha said he expects the S&P to bottom between 1220 and 1260. "Our baseline view is that this should turn out to be a snap-back market like last summer, but it should happen earlier. We do have this long list of concerns just now," said Chadha.

"It's not really about the fundamentals. We think the macro slowing is temporary and we think earnings will be good and early reports show that view. The valuation of equities is favorable, especially to other asset classes," he said.

Last summer, stocks turned higher, shortly after Fed Chairman Ben Bernanke first discussed QE2 in late August. Under the program, the Fed was to purchase $600 billion in Treasury securities, which in theory drove risk asset prices higher and held rates lower. Ironically, rates are at the lowest levels they have been since the Fed started the program in November.

When the Fed stops its so-called QE2 program, Fed watchers expect it will continue to buy about $25 billion of Treasurys a month, as its mortgage holdings roll off.

Chadha said it's a positive for stocks that Bernanke did not suggest a new easing program when he spoke following the Fed's meeting this past week. "What QE2 did was create a lot of risk and we're still living with a lot of them. I don't think the Fed can say that QE was successful. It raised equities prices, but didn't raise oil prices?" he said.

"If the recovery continues and is done without QE3, then a year from now the market should have a lot more confidence in the recovery," he said.

Pierpont Securities chief economist Stephen Stanley said the fact the market continues to focus on the idea of QE3, even as the Fed chairman shoots it down "gives you a hint that the market is focused on the downside possibilities."

"It's pretty ambiguous for most of QE2 what it was doing to Treasury prices, but most everybody agrees it was inflating stock prices. In the last several months, the stock market has given back some of that froth. What we don't know is how much of that is technical around QE2 and how much is a fundamental worsening outlook for the corporate sector," Stanley said.

The three Treasury auctions in the coming week are comprised of $35 billion 2-year notes Monday; $35 5-years Tuesday, and $29 billion 7-year notes on Wednesday.

"The problem we've run into in the last couple of months at the end of QE is the dealers are out of paper. The Fed has kind of sucked the paper out of the Treasury market,' said Stanley. "...It will take awhile to unwind that....It will take a while for all the players who would normally hold paper to reacquire it. It's kind of a one-way market because nobody wants to short it."

Briggs said the fact that the Greek vote comes around the same time as the auctions could "make it a dicey bidding process."

"I think we're near the lows yields of the year, but how do you hedge that with the tail risk of a Greek default or European debt crisis spinning more out of control?" he said.

"Even though I don't like the market here, we think that auto-related issues are going to push (weekly jobless) claims down to around 375,000 in July, which is not what this market is priced for, and falling gasoline prices should feed through to mean a little better confidence, though the decline in equities doesn't help. There are things that could be better for the economy that the bond market is not priced for," Briggs said.

Econorama

Many economists believe the soft patch in the first half of the year will prove transitory. On their list of causes are high oil prices, supply-chain disruptions from the Japanese earthquake and weather-related issues. Bernanke concurred with that assessment in his comments though he did say it's not clear if there are other factors at work.

"I think people are scared and obviously financially set back, and there's less optimism. Just fundamentally it creates its own headwind. That could be something. Obviously, it's intangible and hard to nail down," said Citigroup's chief U.S. economist Robert DiClemente.

Like other economists, he sees improvement in the second half and one of the most measurable areas will be the restarting of lost auto production. "We're looking towards these next couple of months as a transition from those things that had been temporary," he said.

"We're looking in the 3 to 3.5 percent range (for the second-half growth). A lot of that is just autos coming back. It's remarkable how much auto production, as small as it is in the economy can be a huge factor in short-term growth. That's going to be a big factor in the second half," DiClemente said.

The impact from oil is already fading, and oil prices took another big hit this past week. On Thursday, the International Energy Agency and the U.S. energy department announced a program to release 60 million barrels from reserves, even though oil was already about 20 percent off its highs. That knocked crude even lower, and Brent fell more than 7 percent for the week to $105.12 per barrel.

Economists are particularly watching the ISM manufacturing data Friday to see if it has improved from May's level. Monthly auto sales are also released that day, as is consumer sentiment and construction spending. Other data due out are personal income Monday; the S&P/Case-Shiller home prices and consumer confidence Tuesday and pending-home sales Wednesday. Weekly jobless claims and Chicago PMI are Thursday.

Fed speakers in the coming week include Minneapolis Fed President Narayana Kocherlakota, who speaks to a bankers summit in Montana 11am ET Monday, and Kansas City Fed President Tom Hoenig, who speaks in Washington at 1 p.m. on financial reform.

Dallas Fed President Richard Fisher speaks on the economy Tuesday at 1 p.m. and St. Louis Fed President James Bullard speaks Thursday at 10 a.m. on quantitative easing, the day QE2 ends. Hoenig speaks at 1 p.m. that day and Fed Gov. Sarah Bloom Raskin speaks at noon in Washington on economic inclusion.

Treasury Secretary Tim Geithner speaks at the Clinton Global Initiative Thursday.

Questions? Comments? Email us at marketinsider@cnbc.com

  • 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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