After the Fed ruffled markets in the past week, the Treasury's 5-year note auction Wednesday should get more attention than usual as traders watch to see whether the prospect for higher rates has been fully priced in.
There is a key 1 p.m. ET auction of $35 billion in 5-year notes, a part of the curve where yields moved dramatically higher after last week's Fed meeting. That narrowed the gap with 30-year bond yields to the tightest spread since 2009 on expectations by some traders that higher rates at the short-end will now come sooner than expected.
Traders also said that many bond funds were long the 5-year note, and were forced to quickly reposition.
That trade reversed just slightly Tuesday when the 5-year note yield slipped to 1.73 percent, and the 30-year note rose to 3.59 percent.
"The flattening has happened, and it's here," said Tom Simons, money market economist at Jefferies. "I think we've seen the near term flat. The majority of the move is already done."
Fed Chair Janet Yellen jarred markets last Wednesday when she said that there may be around six months between the time the Fed ends its bond buying program and begins to raise rates. Yellen made the comment during her post –meeting briefing.
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"I think the reason for the flattening is something we need to keep in context. I think people looked at what happened in the curve in 2003 ahead of the tightening cycle, and in the mid-90s. A year before the beginning of a tightening cycle, the curve tends to flatten out like this," he said.
Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi, said the market has quickly moved to price in higher rates. "The market is positioning as if they're going to start in June (2015). When they wind down QE, it could be another six months before they move," he said.
"It (the 5-year auction) will be a litmus test to see if there is any more room on the upside for yields. Have we fully priced in these earlier than expected rate hikes?," he said. "Is there another shoe to drop that we don't know about. Are there bad positions out there that tell dealers we've got it wrong?"
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The 5-year auction follows a $32 billion 2-year note auction which saw good demand but light dealer purchases. That raised some concerns for the 5-year auction.
"It's uncommon that 2-year note auctions are interesting. You had the smallest dealer bid since November, 2008. That's a kind of strike against the market. The 2-year note is very closely tied to expectations for near term Fed policy," said Simons.
"I think the confusion generated by the March 19 FOMC statement and Yellen's press conference following it obviously created a lot of volatility in the front end of the market. Dealers are kind of leery of getting involved in a big way. It's also quarter-end which is probably another reason why the bid was so robust."
While the bond market priced in higher short terms rates since the Fed meeting, the stock market has seen a shakeout of its own, particularly in the once high-flying biotechs.
The iShares Nadaq biotech ETF, IBB, was flattish but 0.1 percent higher Tuesday, after several days of selling in high flying biotechs. While those stocks were sold, along with momentum names, investors moved into financials, which benefit from higher interest rates.
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The Dow closed 91 points higher at 16,367, and the S&P 500 was up 8 at 1865.
According to Bespoke, banks are up 2.5 percent since the Fed statement was released while biotechs and drug company shares were down 3.4 percent.
Paul Hickey, co-founder of Bespoke, said the market is in a rotation. He pointed out that the 150 best performing stocks of 2013 in the S&P 500 were down 1.4 percent for the year as of Tuesday morning, while all the other stocks averaged a gain of 0.1 percent.
Hickey also noted the gusher of IPOs, including the $500 million Candy Crush game maker King Digital IPO. So far this year, there have been 53 IPOs, raising $8.5 billion, well above last year's level.
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But Hickey points out that for 2014, the number of IPOs raising more than $250 million is only about 8 percent, while in 2013, it was about 25 percent.
While not necessarily signaling a bubble, Hickey did say additional stock on the market from IPOs could affect market gains. "I wouldn't say the market has peaked right now, but the fact is we've had a more volatile 2014," he said. "There were only three years since 1928 that were as devoid of volatility" as 2013.
Besides the bond auctions, durable goods data are expected at 8:30 a.m. and the flash services PMI is out at 8:58 a.m.