Traders Debate Fed Moves While Japan in Focus

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Higher interest rates are likely to keep Wall Street on edge, while Japanese markets are likely to keep the whole world on edge, ahead of the key U.S. jobs report Friday.

U.S. markets are likely to remain volatile Tuesday, though there is little U.S. economic news, aside from international trade data at 8:30 a.m. ET.

As traders debate whether the Fed will see strong enough jobs growth to back away from some of its easing, they are also keeping an eye on Japan where as of Monday, stocks fell 15 percent in just eight sessions after a breathtaking run.

The outcome of the auction of 2.4 trillion yen in 10-year Japanese Government bonds Tuesday will be important, and traders are anticipating some word this week from Japanese Prime Minister Shinzo Abe on further plans to stimulate the economy. Reuters quoted sources Monday saying that the Japanese government is set to encourage its public pension funds, with more than $2 trillion, to boost investments in equities and overseas assets as part of Abe's growth strategy.

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Markets will also likely focus on the words of Fed hawk and dissenter Kansas City Fed President Esther George, when she speaks at 1:30 p.m. ET. Dallas Fed President Richard Fisher, who does not vote, speaks in the evening.

San Francisco Fed President John Williams and Atlanta Fed President Dennis Lockhart both said Monday if the job market is strong enough, the Fed could start paring back its $85 billion monthly purchases of mortgage and Treasury securities.

The "tapering talk" has also made Friday's May jobs report one of the more important data releases in quite a while, as traders expect rates and risk assets to tilt either more toward or away from Fed easing plans based on that number. Economists are expecting to see 170,000 nonfarm payrolls added in May, after an increase of 165,000 jobs in April, according to Reuters data. The Fed is expected to use a series of monthly employment reports to make its decision, but traders say this one report could be key in helping to decipher the trend.

An environment where rates have been rising has introduced more volatility to the stock market, which seesawed Monday. The Dow ending with a flamboyant 138-point late day gain, at 15,254, after trading in a wide range. The S&P 500 was up 9 at 1640, after touching down at 1622 after a surprisingly weak ISM report showed the first contraction in manufacturing since November. The Nasdaq staged an impressive turnaround, declining more than 25 points before ending with a gain of 9 at 3465. The 10-year ended flattish with the yield at 2.13 percent in late trading.

"You can have within the same day some pretty substantial intraday swings," said Ed Keon, portfolio manager at Quantitative Asset Management. "People are trying to make sense of this new information, and they are trying to make sense of it in light of what has been a strong rally for stocks this year, and in fact a couple of years…We come down on the bullish side but there are people who say the market could be hurt by a change in Fed policy and higher rates. It's one (time) where the market is not crystal clear, and bulls and bears are slugging it out."

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As for Japan, the volatility there continued during the U.S. trading day Monday, with Nikkei futures down more than three percent, after the Nikkei closed down 3.7 percent Monday.

William O'Donnell, head U.S. Treasury strategist at RBS, said he expects U.S. rates to remain elevated going into the nonfarm payrolls report Friday, but that the U.S. markets are also keeping an eye on Japan. "Stocks are watching bonds and bonds are watching stocks and stocks are also watching JGBs (Japanese Government Bonds)," he said.

The yen rose in U.S. trading, with dollar/yen falling below 100. "Look at today's biggest losers. The favorite of all the yen-based accounts was long the Nikkei, short yen and long dollar. Now you have the dollar index down hard, and you have the Nikkei down hard. I think the genesis of (higher rates and market volatility) wasn't just the Fed's tapering talk which we thinks is understandable given where we are in the calendar, but more importantly this spark of volatility that was generated in Japan and dispersed into all the global markets where investors got caught," he said. He noted the 10-year Japanese bond, which was yielding 0.83 percent in early Asia trade, had traveled as high as 1 percent, more than doubling in a short period.

O'Donnell said it does not seem U.S. rates will go much higher in the near term. "There seems to be upward between 2.2 and 2.25 percent a barrier of demand that I think is going to make it very difficult for rates to go much higher. We're looking for a range of 2.06 to 2.23 going all the way into Friday," he said. And after that, it depends on the jobs report and what traders believe the Fed will do. Before the last jobs report, the 10-year was yielding just above 1.6 percent.

"I'd be surprised over the next three months for 10s to go above 2.4. In my view, if we go above 2.4 that will be the concrete sign that the secular bull trend is over," he said. The 10-year was last at that level in August, 2011.

MacNeil Curry, global head of technical strategy at Bank of America Merrill Lynch, said he expects U.S. rates to move higher, and it is likely stocks will decline a bit more. He said he does not anticipate a big impact on stocks from higher rates unless there is a rapid move.

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"I would argue what's more important is the rate of change rather than the level of yields...a disorderly move is negative, while a slow orderly grind higher is not," Curry said. "There are pockets from which convexity hedging (for mortgages) will become an issue. 2.20 2.30 and north of 2.40. At those points, you could see this thing become disorderly."

Curry said he believes the Treasury market is consolidating near term. But the fact that yields finished May higher than in April, and they traded in a range that encapsulated the prior month move, it could be important for a rising trend in yields. "May encapsulated the previous month. That's unusual and it usually predicts higher yields going forward. If you look at 10-year yields, after a bearish outside month, a probability of higher rates the next month is 78 percent," he said.

If the S&P sees more selling, Curry said it would find support at 1620. Below that, a key level is 1600.

Keon said he does not expect higher rates to hurt stocks. "There's always nervousness in the market when you make a shift to a different environment," he said. In the next year, the environment should still be good for stocks, despite the drag from Washington's spending cuts. "That's going to go away. I think the underlying strength of the economy is going to shine through and you're going to get more like four or five percent GDP, but you're also going to have higher rates and a less easy Fed."