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Watch Interest Rates and Prepare for an Increase in Volatility

Equity markets are trading higher overnight after regaining about 50% of yesterday's break. Investors continue to express their concerns about the direction of interest rates at this time.

Today stock traders will be watching the June Treasury Notes and June Treasury Bonds as the government conducts another key auction to raise money to fund the growing deficit. Additional pressure will be on trader's minds because of the release of last month's retail sales results.

The biggest fear affecting traders is the thought that rising bond yields will limit the gains the economy has been experiencing recently. Recent reports have demonstrated that the economy is beginning to experience a turnaround, but the threat of higher interest rates has been real enough to keep many traders on the sidelines.

Yesterday's auction sent Treasury Bond yields near 4%. Today the U.S. is due to auction off another $11 billion in debt. A substantial rise above 4% is likely to put downside pressure on the equity markets.

The trading action over the past two weeks shows higher-highs, but it also reveals that investors have been unwilling to chase the market following gap-higher openings. This was especially clear yesterday when the market opened stronger and failed. Most of yesterday's late buying came in following a substantial decline in price.

May retail sales will be reported this morning. Investors are expecting the first increase in three months. Traders will be looking for visible signs of an economic recovery and will react accordingly. An increase in retail sales will be a sign that consumers have been gaining enough confidence in an economic recovery to begin spending again.

One issue from yesterday which could linger today is the announcement by Russia of its intention to cut its holdings of U.S. Treasuries. This announcement helped put in an early top in the equity markets and chased traders into lower risk assets.

The Russian news affected financial futures and the U.S. Dollar yesterday. The Treasury Bond market fell hard as yields shot up as traders braced themselves for more supply and less demand for Treasuries in the future.

It may take a few days for the Forex markets to adjust to the Russian threat. In the meantime, volatility could pick up as a rally in the Dollar may catch many traders by surprise. After the huge drop in the Dollar, short positions have to be large. Yesterday's trading action in the major currencies indicates that Dollar buyers may have already stepped in. A rally by the Dollar through Monday's high may ignite the start of a massive short-covering rally.

Financial market traders should continue to focus mainly on interest rates for direction. A substantial spike in long-term rates over the 4% mark could frighten traders out of equities today and into the safety of the U.S. Dollar.

Traders should also continue to monitor Russia's threat to curtail their purchases of U.S. Treasury instruments. If they follow-through on their threat then interest rates will surely rise as Treasury supply will grow while demand drops. Given the weakness in the global economy, it is difficult to believe at this time that China or Japan would be willing to pick up the extra supply.

In summary, watch interest rates closely and be prepared for an increase in volatility.


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