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Friday Look Ahead: Stocks Close Out Week Watching Europe, Rates and Waiting for Santa

Stocks should take Friday's futures and options expiration in stride, as traders set up for the final two weeks of the year and the chance that Santa's rally is yet to come.

Traders at the New York Stock Exchange.
Photo: Oliver Quillia for CNBC.com
Traders at the New York Stock Exchange.

The Dow finished Thursday with a gain of 41, at 11,499, and the S&P rose 7 to 1242. The bond market, which has been highly volatile this week, showed signs of calming, and the yield on the 10-year fell to 3.473 percent from above 3.5 percent, the day earlier.

"I can see rates backing up 3.5 to 4 percent, and the stock market still going higher," said John O'Donoghue, who heads stock trading at Cowen. Some analysts say the 4 percent level is where the stock market would start to react negatively to higher yields.

O'Donoghue expects the stock market to trend quietly higher into year end. "I think it will be very slow. I think they're going to try to jam them toward the highs of the year at the end of the year," he said.

He expects the focus in the first quarter to be on Europe, as sovereign bond issuance picks up in January. "I think the biggest issue is Europe...you might have some new money committed to the market place (in January). Then I think you could have a pretty snappy correction here," he said, noting he wouldn't be surprised to see a 5 to 10 percent decline early in the year.

There is little to watch Friday, aside from the second day of a European Union leader summit in Brussels, and U.S. leading indicators at 10 a.m. Tech stocks may benefit from both Oracle and Research in Motion, which were moving higher after late day earnings reports Thursday.

The bond market will also continue to get attention. David Ader, chief Treasury strategist at CRT Capital, said the worst of the selling may be coming to an end for now.

"Technical momentum and market sentiment indicators, measurable things, are extremely oversold. The last time we saw these at these levels, we corrected 40 to 75 basis points," said Ader.

"It's finding a footing here, and people were less interested in selling into it.," said Ader. "As long as we're able to hold in here, it will give some people encouragement. Not that they'll want to buy, but they won't want to sell anymore."

Ader said he expects to see the 10-year yield in the 2.75 to 3.75 percent range next year. "I think six weeks form today, yields will be 50 to 75 bps lower," he said.

The reasons behind the big bond sell off is debatable, but traders say it has to do with better news on the economy and overly aggressive positioning ahead of the Fed's easing program. The Fed initiated its quantitative easing program at its November meeting, but it had broadcast the Treasury securities purchase plan to the markets since late August.

Under the plan, the Fed expects to buy $600 billion in Treasury securities by the end of the first half of 2011. It was expected to result in lower rates, but rates have instead moved higher since bottoming in October.

The bond move is also being blamed on rising inflation expectations, as well as fears the budget deficit will continue to grow. The tax compromise package, before the House Thursday night, is one reason the market has been spooked. Traders point to the dual concerns that it will add to the deficit, and the fact that economists say it will improve U.S. economic growth next year.

The dollar was slightly higher against the euro Thursday, as European Union leaders agreed to set up a permanent crisis management mechanism. The leaders summit continues Friday.

"I think the market is looking longer term and knows these policy announcements don't have the same impact as they initially did. I think it's hard for them to engineer a specific statement that's going to have a market impact," said Jens Nordvig, global head of G-10 foreign exchange strategy at Nomura. "What matters more is the fundamental news that is coming out."

"They certainly don't agree. Clearly some favor issuing euro bonds. Oother people are completely against that idea, so there's no agreement whatsoever," he said.

Nordvig said another issue for the currency market could be U.S. interest rates, if they continue to rise.

"U.S. rates are moving rather dramatically. It's a quite dislocated market at the moment. The currency market does not believe what it sees in the interest rate market. We have had a very dramatic move. 100 basis points in a very short period of time, and the dollar has been only slightly stronger. It's almost like the dollar is still hanging on the QE2 (quantitative easing) effect, and the QE2 has already come out of the yield curve. If rates go higher, we'll be in a phase where the dollar will play catch up," he said.

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