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Stock markets keeping a wary eye on interest rates

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A whiff of Fed 'taper talk' and a 10-year note auction Wednesday should keep the stock market focused on interest rates.

Stocks struggled and the dollar rallied, as Treasury yields rose Tuesday amid speculation the Fed could move sooner-than-expected to slow its $85 billion bond buying program. The strong October jobs report Friday put the possibility of a Fed tapering back in play for December or January, but many Fed watchers still believe the Fed will not pare back its quantitative easing program until early next year.

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Yet, the bond market has moved forward, with the 10-year yield going from about 2.6 percent, before the jobs report to 2.78 percent by Tuesday afternoon. Stocks, wary of the sting of rising rates, were mixed with the down 32 Tuesday at 15,750, and the S&P 500 off 4 to 1767. The was flat, with less than a 1 point gain, at 3919.

'Generational buy' for stocks: Pro
'Generational buy' for stocks: Pro

Comments from Fed officials stirred up the talk even more. Hawkish Dallas Fed President Richard Fisher said that the Fed's QE program cannot continue forever. Atlanta Fed President Dennis Lockhart, a dove, was quoted by Bloomberg as saying that Fed tapering of bond purchases "ought to be on the table at upcoming meetings," but he said he would like to see inflation accelerate before the Fed makes a move. Both Lockhart and Minneapolis Fed President Narayana Kocherlakota said Fed policy should remain accommodative.

Fed speakers Wednesday include Cleveland Fed President Sandra Pianalto who speaks at 8:45 a.m. ET on women and the economy, and Fed Chairman Ben Bernanke who appears at a 7 p.m. town hall with teachers commemorating the Fed's 100 years.

"You get a few more Fed speeches and then you have Yellen's testimony on Thursday. That's obviously a big deal, and I would guess she doesn't want to be cast as an 'uber' dove. I think as a result she could come off as more hawkish," said Barry Knapp, head of equity portfolio strategy at Barclays.

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Fed Vice Chair Janet Yellen, nominated to replace Bernanke, will be testifying at a confirmation hearing before the Senate Banking Committee Thursday morning. She is expected to be grilled about Fed policy but refrain from major policy statements.

"When you put someone in front of a group of senators that are trying to grandstand…you could potentially get her to come off saying something more hawkish or dovish than she would want to, and you might get some volatility," said Brett Rose, head of U.S. interest rate strategy at Citigroup. "It has the opportunity to create some headlines across the tape and people won't read the whole testimony."

With a dearth of economic data, a big event Wednesday will be the Treasury's auction of $24 billion in 10-year notes at 1 p.m.

"I think demand will show up. There has been expressed interest between 2.75 and 3 percent. There's a question of whether people will want to put money to work ahead of Yellen. That should be more favorable for the auction than not," said John Briggs, head of cross asset strategy at RBS. Briggs said the new 10-year was already trading to yield 2.80 [percent] on a when-issued basis Tuesday.

Stocks are good, bonds are bad: Pro
Stocks are good, bonds are bad: Pro

"I'd be more comfortable with the auction coming at 2.85 percent . It will probably be okay here, if we back up (in yield) tomorrow," said Briggs, adding he expects only a modest move higher. The 10-year yield briefly reached a high of 3 percent before the Fed's September meeting.

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Rose said the move higher in rates since Friday was a bit more than he had been forecasting, but it was in line with the jobs data. "We look at the misses versus the consensus and then we add the previous month's revision and regress that with its rate change. This year it's about 16 basis point per 100,000 miss," he said.

Friday's employment report showed the economy added 204,000 jobs in October, well above the 125,000 expected by economists, and a shocker to a market that expected to see a big miss rather than a gain due to the government shutdown. Another 60,000 jobs were added to August and September in revisions.

"People are talking a little more about December tapering than they were on Friday," Rose said. He said if the next jobs report is also strong that could move the Fed's timetable, and that could move rates higher.

He noted that the 10-year was at 2.85 percent in September when many investors believed the Fed was about to announce a tapering of its QE program. So that would be a reasonable level if it seems like the Fed would taper.

Rose expects the auction to go well. "I think demand will be there. We've got the best level that we've had coming into an auction since September," he said.

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Knapp said the stock market is keeping a close eye on rates, but he does not expect the stock market to react badly yet.

"We're in this period of seasonality and it's pretty rare that the market would get rocked at this time of year," he said. "My feeling is the stock market is going to have to really get hit over the head with tapering before it starts believing it."

Some analysts say stocks will adjust to higher rates as long as they do not move higher too quickly.

Knapp said his concern is that the Fed will not be able to keep rates under control while it winds down its asset purchases. "The Fed is trying to decouple interest rate policy from asset purchases," he said, noting the Fed would like to keep its short term Fed fund target rate lower for longer. Knapp said the market could start moving ahead of the Fed as it begins tapering, on expectations that it will raise rates.

He expects the economy to do better next year, and accelerate. While stocks should do well, he expects them to hit a rough spot when the Fed tapers.

(Read more: Jobs shocker may force Fed hand on slowing easing)

What Else to Watch

The Federal budget is released at 2 p.m. Wednesday. Earnings are expected from Macy'sand Canadian Solar, before the bell. Cisco, NetApp and Seaworld report after the closing bell.

Markets are also watching the steep decline in oil prices, which have been helping bring down the price of gasoline. According to AAA, the national average for gasoline was $3.18 a gallon Tuesday.

The Fed speculation was a factor in oil markets Tuesday, but the bigger weight on prices was from expectations that the government data Thursday will show another build in supply.

John Kilduff of Again Capital said the renewed strength of the dollar was also hurting oil.

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West Texas Intermediate oil fell further after breaking below last week's low of $93.07, and traded below $93 for first time since June 24. WTI settled at $93.04, its lowest settlement since May 31.

API releases its inventory data Wednesday afternoon.

"What happened is the market kept falling and once we got close to last week's four month low, it triggered another wave of technical selling. Basically it expanded the lower side of our trading range." said Gene McGillian, analyst with Tradition Energy.

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