It's Always the Quiet Ones: Week Ahead Could Be Slow but Pivotal

The holiday-shortened week may sport low volume, but Wall Street will eye Japan's tankan report for clues to the course of rates.
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Looks can be deceiving.

A glance at the calendar for the coming week, and it doesn't look like there's going to be a heck of a lot going on. Holiday-shortened, no economic reports to speak of, earnings still another week away -- plenty of traders have opted to extend their three-day weekends into weeklong vacations. And yet while there will probably be a dearth of players, it could end up being a pivotal week for both the stock and bond markets.

For stock investors, it's a matter of focus -- will the market's attention again be wrapped up in what's going on in the bond market, or will it focus, as it began to in the week just finished, on the forthcoming earnings season? An earnings season that, so long as people aren't too worried about the rate environment, could send stocks sharply higher in the next few weeks.

According to Peter Canelo, U.S. investment strategist at

Morgan Stanley Dean Witter

, it looks like the U.S. economy posted another 4% gain in the second quarter. "That means we're going to see some very good earnings," he said. Street forecasts call for

S&P 500

earnings to gain about 10% in the second quarter, "but given the usual surprises, I'd say minimum that it's a 12% or 13% quarter," said Canelo.

In the meantime, Canelo believes that it is unlikely the


will move again on rates at the August meeting. That should lend, at the least, a bit of stability to the bond market, allowing stocks to be driven by earnings. With tech earnings looking to add about 40%, so money should rotate back into the sector. Canelo also thinks financials could be a hotspot when the banking-reform bill cruising through


gains final approval. And retailers, though they don't report results until August, stand to benefit from the strength of consumer demand.

Yet others are unsure whether the stock market is ready to take its eye off the bond-market ball just yet. Hugh Johnson, chief investment officer at

First Albany

, worries that the market may reassess its somewhat bizarre reaction to the Thursday's

Purchasing Managers Index

and Friday's

employment report

. Both reports came in stronger than expected, yet stocks put on good moves.

"It's very clear the economy is strong," said Johnson. "There's some upward pressure on wages and in time there will be upward pressure on prices."

But while fixed-income players believe supply concerns will weigh on bonds in the coming week, and don't think that the Treasuries will be able to make any headway until there are signs that demand is moderating, it is doubtful there will be anything to prompt severe selling.

Tankan Could Shake Everything Up

The only thing that might throw a wrench into that scenario comes from Japan. Monday, the

Bank of Japan

releases the closely followed


, a quarterly index of business sentiment. Economists forecast that the tankan will improve significantly. Consensus estimates call for the diffusion index for large manufacturers, the part of the report that gets the most attention, to improve from minus 47 to minus 35.

If the tankan came in significantly better than that -- say, minus 4 -- the BOJ would likely upgrade its outlook on the economy, said Michael Hartnett, international economist at

Merrill Lynch

. The prospect of that would send the Japanese government-bond market sharply lower and would likely send world bond markets into a tizzy.

But though there's a good chance that the recent strong GDP report and the jump in the


means the tankan will come in better than expectations, an extremely strong report seems unlikely. Of the 24 firms polled by the

Nihon Keizai Shimbun

, the strongest tankan forecast, from

Goldman Sachs

, is for the diffusion index to come in at minus 28. That would trouble the Treasury market, no doubt, but it's a stretch to think it would send yields to new highs.

So long as that doesn't happen, stocks may be able to whistle past the bond-market graveyard.