Rising Rates Have the Attention of Stock Market

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Stock traders have their eyes on the bond market this week, as interest rates continue to adjust higher.

The issue is just how much higher, and that will certainly be a topic of interest on Tuesday when there is little data for markets to chew on.

"I think the fact the bond market has just continued this relentless increase in rates is clearly negative news to the equity market. We're well past the 30 basis points benign increase," said Barry Knapp, head of U.S. equity portfolio strategy at Barclays. "We went from 2 percent (10-year yield) early in the year, back to 1.60, then you got back to 2 percent. Anything from here becomes a bigger and bigger issue."

The 10-year yield Monday continued to rise, reaching 2.211 percent, its highest level since April. Yields also rose after Friday's jobs report showed 175,000 jobs were created, signaling some bond market participants that the Fed could begin paring back on its bond purchases, sometime after the summer.

Treasurys were also weaker Monday ahead of $66 billion in auctions this week. The Treasury auctions $32 billion in 3-year notes Tuesday at 1 p.m ET; $21 billion of 10-years Wednesday, and $14 billion of 30-year bonds Thursday. There was also talk that new collateral rules for the over-the counter derivatives market will require swaps traders to increase collateral holdings, and that could mean hundreds of billions of dollars of more demand for Treasurys, driving rates lower.

There is little data that can stir the markets this week, though traders are watching Thursday's retail sales and producer prices Friday. On Tuesday, there is the NFIB small business survey at 7:30 a.m.; wholesale trade at 10 a.m. and the Treasury's JOLTS report on job openings and layoffs at 10 a.m.

(Read More: Fed's Bullard: Low Inflation Means Fed Can Stay Aggressive)

Stocks traded listlessly Monday, with the Dow ending down 9 at 15,238 and the S&P 500 off less than a point at 1642.

"We're well past the 30 basis points benign increase (in 10-year yields)," said Knapp. "We have not had a move like this in this business cycle. The entire move higher in yields was driven by real interest rates. We had a big move in Treasurys in late 2010/2011 when it looked the economy was gaining momentum. We had a 120 basis points move in 10s before it faded. That one was driven by a combination of rising inflation expectations and rising real interest rates…This is being driven by real interest rates. That's on expectations about the Fed."

Goldman Sachs economists, in a note, said super low inflation may be one reason the Fed will not taper until the end of the year. "It would be risky to test the stability of inflation expectations by delivering a hawkish monetary policy surprise at a time when actual inflation is so low. Our baseline thus remains that the committee will first reduce the QE pace at the December FOMC meeting. An earlier move in September is possible if employment surprises on the upside and inflation moves back toward the target, but so is a later one."

Markets have been tense for the past several weeks, as talk picked up that the Fed could start to wind down some of its $85 billion in bond purchases. That talk has been driven by comments from Fed officials, some of whom believe the Fed should wind down purchases now. Even dovish Fed Chairman Ben Bernanke spooked markets when he said the Fed could start tapering back its purchases in the next couple of months if the economy proves strong enough.

(Read More: For Some Investors, Federal Reserve Can Start Tapering NOW)

Zane Brown, Lord Abbett fixed income strategist, doesn't see rates rising that much more for now, and he said many in the markets are ignoring the Fed's comments that it will need to see improvement in the economy in order to taper. "Now there's fear the Fed will still unwind, and nobody's paying attention to the Fed's requirement that you have self-sustaining economic growth before they start doing it," he said.

"I think we are close to a turning point in terms of Fed comments and maybe even quantitative easing policy," he said, noting the tapering talk has driven 30-year mortgage rates above 4 percent, a risk for housing's recovery.

Brown said fixed income looks cheaper than it did a month ago and the selling is overdone, in anticipation of the Fed pulling back. Equities still look favorable, especially if investors expect the economy to improve.

"It could be an inflection point, especially if you have investors look at their May statement and see losses in high quality fixed income. That could provoke the start of the great rotation," he said.

Brown said the Fed will likely do something to stop the rise in yields if it continues. "The jawboning probably begins within the FOMC at this next meeting, and they could provide a more uniform message from the Fed which could help their own cause and cause less volatility in the market," he said. The Fed's next meeting is next week, ending Wednesday with a Bernanke press briefing.

(Read More: Bond Sell-Off Heightens Risk of '1994 Moment')

Knapp said if history is a guide, first interest rate sensitive stocks sell off, which has happened, then cyclicals get hit. If the Fed actually moves to pare back easing and the economy is not improving, earnings will not improve. "You're sort of in a lose, lose in terms of buying the cyclicals," he said. "They will go down more if it's not the real deal and ISM is sending the right signal about what's going on with growth, then the cyclicals are ahead of themselves."

What Else to Watch

Traders were watching to see the outcome of the Bank of Japan meeting overnight, after Japanese stocks gained five percent Monday on better GDP and a weaker yen.

Germany's federal constitutional court holds the first day of hearings on the legality of the European Central Bank's bond buying program, or OMT. The Bundesbank's Jens Weidmann is opposed to it and he has said it is a direct funding of government budgets, threatening the ECB's independence and hurting its mandate of price stability.

(Read More: Mario Draghi Goes on a German Charm Offensive)

E3, the videogame trade show, starts in Los Angeles.

Lululemon holds its shareholders meeting and it will be in the spotlight after its stock fell more than 12 percent in the after hours session. The company announced Monday that CEO Christine Day will step down. The news came a few months after the company had to recall one of its yoga pants for being too sheer.

Facebook also holds its annual meeting.

Texas Instruments slid in after hours trading after its second quarter outlook. The company said PCs and notebooks are weak this quarter, as it had expected.