Markets' Next Worry May Be Rising Rates

There's growing concern that rising interest rates could become a hurdle for stocks, just as the tentative tax dealclears away some uncertainty.

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"The level of interest rates are beginning to concern me. They are historically low, but the direction could impact equity gains," says Peter Boockvar, equity strategist at Miller Tabak.

"QE2 in front of our eyes is failing," said Boockvar. "If (Fed chairman Ben) Bernanke's purpose was to keep interest rates low...they're moving higher." He said the fact that commodities have been rising is another concern, as inflation could also help push rates higher.

Stocks gained around the world Tuesday after President Obama announced a tentative tax deal that would extend the Bush-era tax cuts for all taxpayers. That includes keeping the capital gains and dividend rate at a maximum 15 percent, a plus for stocks.

But it's the 10-year yield that markets are watching. Yields on the 10-year broke out above 3.06 percent Tuesday, a key technical level. The yield jumped to 3.116 around the Treasury's 3-year auction Tuesday afternoon, in anticipation of the auction of $21 billion in reopened 10-year notes Wednesday.

Some bond traders say the move above 3.06 opened the door for a move straight to 3.2 percent or higher.

"At above 3 percent, I'm saying 'uh oh,'" said Boockvar, but added that to start to stall the rally, rates would have to be above 3.5 percent. "We're not going to handle that well."

Boockvar said the tax compromise, if approved, would have a positive impact in that it changes psychology, but it's not a big factor for stocks. "It's just the lack of a negative, instead of a positive. The only positive is the intangible," he said.

The Buy America Bonds Problem

There's also a lot of buzz around about how the tentative tax compromise allows the Buy America Bonds program to fade away.

Peter Delahunt of Raymond James says the elimination of the Buy America Bonds should cause a dramatic steepening in the tax-exempt yield curve. That's because issuers that may have used the BABs program would have to issue tax-exempt bonds, boosting supply at the same time demand for tax-free issues has been diminishing.

Retail investors, through municipal bond funds, are the big buyers of muni bonds, and those bond funds have seen significant outflows recently. The lack of buying interest could also pressure the market as supply builds. BABs, on the other hand, had attracted institutional buyers, like insurance companies, foreign banks and pension funds.

Delahunt notes there's no dramatic steepening yet, because some investors still believe BABs are a bargaining chip that could be put back in to any tax compromise.

Delahunt says BABs have gone from about 23 percent of new issue municipal supply over the past year, to about 36 percent in the past two weeks, as issuers rushed to get offers out ahead of the program expiration.

"Come January 1, the supply is going to increase by 25 to 35 percent. The curve has got to steepen," he said.

The biggest issuers of BABs are California, New York and Illinois, so there's more political impact from extending individual tax credits, he notes.

BABs were included in the American Recovery and Reinvestment Act signed into law in February 2009. The bonds are unlike tax-exempt munis but can be used for the same purposes. They receive a direct federal subsidy payment for a portion of their borrowing costs, equal to 35 percent of the total coupon paid to investors.

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