Traders are watching two big things to determine if the market's comeback rally is for real

Published Fri, Sep 24 20217:12 AM EDTUpdated Fri, Sep 24 20219:21 AM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

The strength of Thursday's rally took many pros by surprise, and now strategists are watching two important market metrics to see if stocks can stay on a firmer footing and successfully shake off the September blues. One is the 10-year Treasury yield , which zipped higher to 1.43% Thursday afternoon from 1.31% right after the Federal Reserve meeting Wednesday. Yields move opposite price, and a higher yield is viewed as a sign of positive growth, but if it moves too high or too quickly, it's a negative for stocks. The other metric investors are watching is the S & P 500's 50-day moving average , which the index regained at Thursday's open and then held above for the first time since Friday. The S & P 500 closed at 4,448, up 1.2%. The 50-day is basically the average of the last 50 closes, and if the index holds above it, that could point to further gains. Thursday's stock rally came amid expectations that property giant China Evergrande would pay its debts and China would not let a failure by the firm spread contagion through the financial sector. There was also news from Washington on Thursday morning that Democrats agreed to a framework to pay for their proposed $3.5 trillion reconciliation package, and that helped boost bond yields and stocks. "It sounds like we got some positive news about China. The Democrats are trying to show that they are making progress," said Mark Cabana, head of short U.S. rate strategy at Bank of America. "Those are two big elements of risk on. Rates are responding somewhat to that, but it is also coming in the context of more hawkish central banks around the world. It's coming in the context of a market that was maybe looking for a clear break one way or other, and we may be seeing some of that break today." Cabana does not expect the 10-year to move all that much more, but he said the direction seems higher for now. His year-end target is 1.55%. "10s have been very range bound. This is the highest level we've seen since mid-July. Does it sustain? I don't know, but it is a bit of a break," he said. As for the stock market, Leuthold's James Paulsen said there appeared to be a return of the economic reopening trade Thursday, with the 10-year yield rising, and small cap and cyclical stocks leading the market higher. The small cap Russell 2000 outpaced other indexes, to close 1.8% higher, compared with the 1.2% gain in the S & P 500. The energy sector was the top performing, gaining 3.4%. "I think underneath all of this is that Covid is peaking , and cases are starting to come down, and that is going to be another reopening cycle replay," said Paulsen, Leuthold's chief investment strategist. "Every time you get a leadership shift away from tech and defensives, back to cyclicals and small caps, yields go up, commodity prices go up, and confidence improves." September is usually a negative period for stocks, and this past week certainly put that theory to the test. The week started off with a steep sell-off on fears of contagion from a potential messy default by Evergrande. Then there was a day of stability Tuesday, before the market whipped around Wednesday as the Fed met. By Thursday, there was a full-blown rally in the stock market. State Street's Michael Arone said risks remain, but the market moved past three fears that worried investors earlier in the week. One was Evergrande, the other was that the Fed would move too quickly to reverse policy. The third was the idea that the S & P would fall below its 50-day moving average and trigger technical selling. The Fed on Wednesday, as many expected, signaled it would announce tapering this year, and Fed watchers now say it is likely to be in November. Yet Arone said that was still a relief that the announcement about slowing bond purchases was not made Wednesday. "The Fed decided to punt on the tapering announcement for now based on the challenges the economy was facing," said Arone, chief investment strategist for the US SPDR Business at State Street Global Advisors. He noted a negative was that jobless claims edged back up in the past week, on a possible Covid impact. That follows a weaker than expected August employment report. Still, the Fed sent a hawkish message that it will be ready to roll back its $120 billion in monthly bond purchases soon, and Fed Chairman Jerome Powell said he hoped to complete the wind down by mid-2022. That then opens the door to interest rate hikes, with half of 18 Fed officials forecasting one or two for next year. "I think investors are taking this as a signal the Fed is confident that beyond a temporary setback, the recovery still has a solid foundation. They're interpreting this as if we could move past the delta variant and some of the dysfunction in D.C., then this recovery will regain some serious traction," Arone said. Paulsen said investors have been bracing for the worst. "The problem I've had with this fear trade that was emerging is it was all too pat for me. You start the month of September, the worst seasonal month, with all of us knowing the stock market is due for a correction," he said. Month to date, the S & P is down 1.6%. "You go into September. You still have Covid going up. You know the Fed meeting is coming up. I just wonder if it was all overdone, not just this week but since day one of September. How many Wall Street firms came out and warned people about pending volatility?" he said. "Everyone did that." Paulsen said the 10-year has been the best leading indicator for stocks since the pandemic began. The yield would move lower ahead of the stock market, and begin to reverse ahead of a recovery. Jim Caron, head of macro strategies for global fixed income at Morgan Stanley Investment Management, said he expects the 10-year yield to keep moving higher for now. He also expects some of the market's worries to go away. Congress, for instance, will raise the debt ceiling and avoid a crisis, meaning more Treasurys will be on the market to fund federal spending, he said. "You're going to fund the government. My view is we're going to the 1.80% [yield], back to where we were in March," he said. "It's because inflation is going to stay stickier. It's not going to come down as much, and the Fed is starting to think about tapering. … That's another bearish component." The Fed is currently buying $80 billion a month in Treasurys and $40 billion in mortgage-backed securities. In its new interest rate forecast released Wednesday, Fed officials targeted a rate of 1.75% for 2024. Caron said inflation will still be running ahead of the Fed's rate forecast at that point. "If we think about inflation that hangs around 2% to 2.5% level and the Fed hikes rates … to 1.75%, you're still going to have a negative policy rate, which is expansionary, not tightening," he said.