Stocks are likely to take their cue from the bond market in the coming week, as traders worry low yields are a warning that the economy is not springing back.
Even with the choppy trading of the past week, the Nasdaq eked out a small gain while the Dow, and Russell 2000 were all lower. The 10-year yield, a lightning rod for stocks, rose to 2.519 percent after better-than-expected housing starts Friday.
The week ahead is light on economic data, but much of what is available will have to do with housing—an area of concern. Existing home sales are Thursday and new home sales are reported Friday. There is also the release of minutes from the last Federal Reserve meeting on Wednesday afternoon, and about a half dozen Fed speakers will be discussing the economy throughout the week.
"The key indicator will be the yield on the 10-year," said Art Cashin, director of floor operations at UBS. "Unless the saloon full of Fed speakers says something to move the market, you've got to watch the 10-year."
The 10-year yield, along with the entire Treasury curve, has been moving lower, reaching 2.47 percent Thursday, the lowest level since July. Some of the decline was due to short covering by investors. Yields, which move lower as bond prices rise, were also moving in lockstep with a global rate move, triggered by expectations the European Central Bank will announce a stimulus plan in June.
Cashin said a big concern for the market is deflation in Europe. However, U.S. CPI and PPI showed a slight pickup in inflation, but the bond market ignored it, and yields moved lower. Data in the past week was mixed, with a 7-year low in jobless claims of 297,000 Thursday. However, disappointing retail sales and unsettled markets added fuel to the argument that the 4-percent growth expected by some economists this quarter may not materialize.
"If the optimism around housing begins to fade in earnest, that would be another stake in the heart of the growth story for this year," said Stephen Stanley, chief economist at Pierpont Securities. Economists expect the final reading on first-quarter GDP will result in a slight decline in growth, and Stanley said he shaved a point off his second-quarter forecast, taking it to 2.75 percent.
He said he reduced his GDP forecast because his expectations for consumption were lowered, after Tuesday's report that April retail sales edged up just 0.1 percent, well below expectations. It was a mixed bag of data, with the Empire State survey strong but weak home builders sentiment. Yet, housing starts jumped to their highest level in six years on the back of mutli-family housing construction.
"This week, in particular, people have been struck by the fact that the market was able to rally in the face of what was not friendly…PPI, CPI, housing starts. Clearly, the economic story is the big picture story…there are bigger flows taking place and I think people are looking more big picture. It's not a case of come in and look at the data at 8:30 and buy them or sell them," Stanley added.
He said the Fed is unlikely to make much news in the release of its minutes, and it's not likely to lay out anything new about its strategy to exit its extraordinary easing policy, as some traders speculated. The housing data will likely be more important, especially since Fed Chair Janet Yellen pointed it out as an area of concern in her recent Congressional testimony.
David Ader, chief Treasury strategist at CRT Capital, said the Treasury market could consolidate in the next couple of sessions.
"It seems to me the market is a little bit tired in here. Without a lot of new information—and we're scrambling around for excuses—the squeeze may or may not have run its course, my inclination is we're going to back up a little bit and test the market's resolve," Ader said.
As for stocks, Wells Fargo Advisors and others are telling clients to use weakness to add to holdings. Gary Thayer, chief macro strategist at Wells Fargo Advisors, says the market should be in for a period of volatility as it sorts out the shifts in bonds.
"We've been still seeing positive fundamentals, and we think that's longer term positive, so we're not changing our view, " Thayer said. "The bond market is signaling that investors are cautious, just like the weakness in small cap stocks is signaling that investors are more cautious this year than last year. That doesn't mean the economy is in trouble."
The small cap Russell 2000 underperformed relative to the major stock market indices in the past week, and it has sunk as much as 10 percent off its March high on an intraday basis. The Russell is now down 9 percent from its peak. Both the S&P 500 and Dow made new highs in the past week. The Dow was off 0.6 percent for the week, at 16,491, and the S&P 500 was down just 0.03 percent at 1,877. The Nasdaq rose 0.9 percent for the week to 3,587.
Thayer said he favors cyclical stocks, and says small caps could see more selling with investors seeking value elsewhere.
"We still think there could be some volatility risk over the next couple of months. The flows into equities seem to be a little more modest right now, and there's some more interest in bonds, and that could create some volatility risk, " he said. "…the market has lost a little momentum. Some investors have seen some of their portfolio come off."
Thayer expects stocks to end the year higher. "I think the market going forward is going to be influenced not by just us, but by what's going on overseas, in their data," he said. The ECB stimulus would be a positive for markets, he said.
"I know investors have been favoring more defensive stocks in the beginning of the year. We would expect that once investor caution dissipates they will come back (to small cap, higher beta) names in the second half of the year, particularly as the economy improves," he said.
12:10 p.m.: San Francisco Fed President John Williams, Dallas Fed President Richard Fisher panel discussion in Dallas on Fed's role
12:50 p.m.: Former Fed Chairman Ben Bernanke at Conference Examining Central Banks' Impact on Prosperity, Dallas
12:30 p.m.: Philadelphia Fed President Charles Plosser on economic outlook
1:00 p.m.: New York Fed President William Dudley on economic outlook
7:00 a.m.: Mortgage Applications
10:00 a.m.: New York Fed's Dudley on regional labor market
11:30 a.m.: Fed Chair Janet Yellen at NYU graduation
12:50 p.m.: Minneapolis Fed President Narayana Kocherlakota on monetary policy report
12:50 p.m.: Kansas City Fed President Esther George on economy and banking
2:00 p.m.: Fed minutes
8:30 a.m.: Weekly jobless claims
10:00 a.m.: Existing home sales
10:00 a.m.: Leading indicators
11:00 a.m.: Kansas City Fed survey
4:00 p.m.: San Francisco Fed's Williams
Earnings: Foot Locker
10:00 a.m.: New home sales
—By CNBC's Patti Domm