The bond market is giving the stock market angst.
The yield on the 10-year note has become a barometer for stocks as it hovers near the bottom of this year's range. At the same time, the yield curve has been flattening, meaning yields on shorter-duration securities are getting closer to longer-term rates - usually a bad sign for stocks.
"I think the bond market is what's confusing people and stopping them from putting more money on the line in the equity market," said Scott Redler of T3Live.com. "[Where rates are] is making people in the equity market a little more timid or more skeptical."
Monday's action in both stocks and bonds initially continued Friday's trading pattern, which was weaker stocks and lower yields. That trend kicked in to high gear last week, when first quarter gross domestic product (GDP) came in near zero on Wednesday and when the details of April's seemingly strong employment report looked worrisome to bond traders. Even with a 288,000 jump in payrolls, the lack of a gain in hourly wages and a big drop in the participation rate were seen as signs of economic weakness.
One piece of economic data turned the tide Monday: April ISM nonmanufacturing came in at 55.2, the best reading in six months. The 10-year yield touched 2.57 percent but moved back up to the key 2.60 level after the data, which helped stocks recover early losses and close slightly higher. On Tuesday, the 10-year yield rose to 2.62 percent, and stock futures were flattish ahead of the opening bell.
"Everybody's got the same question - which is why are Treasury yields so low? And the answer is really simple - because everybody thought they were going to be so high," said Jeffrey Rosenberg, Black Rock chief fixed income investment strategist. "I think at the end of the day, the explanations are trying to justify a move…the simplest one is positioning matters. You can't really explain it through fundamentals."
Rosenberg expects yields to move higher from current levels.
"From here, we expect rates to go higher but we expect the largest increase in rates to be led by the front end of the curve. This is a tipping point argument around changes in Fed policy and expectations, and so key to our outlook in 2014 is that this is a transitional year, where the economy really does deliver on its potential and really does bring about not just the end of accommodation but the pricing in of the beginning of tightening," he said.
Rosenberg said he expects the 10-year yield to be about 3.25 to 3.50 percent by the end of the year. The 10-year yield started the year at 3 percent, and many money managers went short, expecting higher rates this year. But the yield has moved lower since Dec. 31 and touched the lows of the year Monday.
"If the bond market declines are really signaling what they normally are signaling, then there's a disconnect in market pricing. The broad market concern is not the level of the 10-year, it's the level of the S&P 500. If the 10-year is right, then the S&P 500 is wrong," he said. The bond market would then be pricing in recession or a growth slowdown. "I don't think it is...I think it's a confluence of pricing in very low first quarter growth when positioning was off sides."
Jeff Gundlach, founder of DoubleLine, told CNBC's Scott Wapner Monday that he thinks the odds of the 10-year yield falling back to its all-time low have increased to about 30 percent because of the big short position. The 10-year hit 1.39 percent in July, 2012 and Gundlach said at that time, he thought the odds were 10 percent but he is now concerned if there's a big move in the market toward lower yields, those shorts would cause a massive squeeze, driving yields even lower.
Traders have passed around plenty of explanations for the recent move lower in long-end yields. A flight to safety due to tensions in Ukraine was one factor, and there was also a lot of talk about pension funds, locking in gains in equities and moving proceeds to the bond market.
"It's a story where the explanation fits the facts," Rosenberg said, noting the pension story is convenient but difficult to prove. "The actual amount of activity to support that story is the missing link," he said. Much like Sasquatch, "you've got foot prints but nobody's seen him."
George Goncalves, head of rate strategy at Nomura, said there was nothing new in the talk about the pension funds, and that does not explain activity in the bond market. However, he did say one motivator for pension funds to move money into bonds may be the result of a change in the way their premiums are calculated by the Pension Benefit Guaranty Corp. They will pay a variable rate premium based on the amount of unfunded vested benefits, and some funds may have been lightening up on stocks because of it.
"Equities have gone up. That helped their funding status so these pension funds don't want to lose that when equities rollover," he said.
But Goncalves also agreed a big factor in the market has to do with positioning and the big short in the bond market. As for the 10-year yield, "15 basis points is Ukraine, and 25 basis points is structural demand, and the fact that everybody is short," he said.
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Goncalves said he is currently neutral on Treasurys. "We're kind of neutral…I would buy on a dip because I think we have another leg lower before it's all over," he said.
Richard Bernstein, CEO of Richard Bernstein Capital Management, said if the move in the bond market were geopolitical, the U.S. dollar would be moving higher.
"What I think is going on is growth has turned out to be a little slower than people thought. There's no inflation, and I think everybody's decided that the long end of the curve is a great place to be," he said.
Bernstein said he's still bullish stocks, even though is concerned about weak earnings growth. He said the flattening curve would not necessarily be a negative for stocks, but the current move is a worry to the market. "That's one of the reasons the market is not performing now," he said.
What to Watch
International trade data for March is reported Tuesday at 8:30 a.m.
There are also dozens of earnings, including UBS, CBOE Holdings, DirecTV, Discovery Communications, Rowan Cos,Northern Tier, HollyFrontier, Mosaic, FirstEnergy, NRG Energy and Vulcan Materials before the bell.
—By CNBC's Patti Domm. Follow her on Twitter @pattidomm.