A Hiccup in the Market's Rose Garden

Citigroup's earnings and higher Treasury yields put a crimp in stocks' recent advance.
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Major indices began a week chockfull of earnings on a cautious note -- perhaps with good reason. Results at

Citigroup

(C) - Get Report

, the largest financial institution in the U.S., disappointed.

Citigroup blamed a flattening yield curve, or a shrinking of the gap between long- and short-term interest rates. This flattening has occurred over the past year as the

Federal Reserve

raised short-term rates while long-term yields remained persistently low. Historically, an inversion of the yield curve -- when short-term rates exceed long-term rates -- has presaged a slowing economy.

Thus, the recent flattening of the curve has had some bulls expecting the Fed will stop raising rates sooner vs. later. Those betting on a pause in the Fed's "measured" tightening campaign have been persistently disappointed, and there was more bad news on that front Monday -- even as long-term yields resumed their recent upturn, effectively widening the curve.

Fed Chairman Alan Greenspan, who gives the last big speech of his tenure as Fed chairman to Congress on Wednesday, said in a letter to Congress on Monday that the flattening curve does not always signal economic weakness, essentially repeating a view he expressed in

early June.

Then and now the message is the same: The Fed will continue raising rates.

The

Dow Jones Industrial Average

fell 65.84 points, or 0.6%, to 10,574.99; the

S&P 500

lost 6.79 points, or 0.6%, to 1221.13; the

Nasdaq Composite

slipped 11.91 points, or 0.6%, to 2144.87.

The tech sector and the broader market were also positioning ahead of key earnings from

IBM

(IBM) - Get Report

after the close. Big Blue was posting strong gains in after-hours trading after

beating estimates by a wide margin. There's more to come from tech bellwethers later this week, including

Google

(GOOG) - Get Report

,

Yahoo!

(YHOO)

,

Microsoft

(MSFT) - Get Report

and

Intel

(INTC) - Get Report

later this week.

Arguably, the downward trend Monday was guided by investors cashing in some of the gains seen over the past seven sessions. Investors therefore chose to focus on the bad news for the day: Citigroup shed 3.1% after posting

soft second-quarter results and said that the capital markets environment was "one of the worst

it has seen in years."

Besides the being technically overbought and in need of a pullback, the market had other reasons for focusing on Citigroup's comments. These reasons were brought home as news of Greenspan's letter hit the bond market. The benchmark 10-year bond fell 13/32 in price while the yield finished at 4.22%, a two-month high.

Yields increasingly bear watching, even as the stock market's attention has so far remained mostly absorbed by earnings. "Yields at two-month highs are enough to slow down this rally" in stocks, says Peter Boockvar, equity strategist at Miller Tabak, who has been persistently cautious in recent weeks.

Capital Competition

The fixed-income arena has taken a decidedly weaker turn since June 30. That day, not coincidently, was when the Fed delivered its ninth rate hike in a row and gave no hint whatsoever of being close to ending its yearlong campaign of lifting interest rates. The yield of the 10-year bond then stood at 3.94%. It had been trading below 4%, on and off, for most of June.

That issue becomes more salient if the yield starts to rise toward the top of its trading range over the past year. "Towards 4.3% to 4.4%, you look at the S&P 500 being up 1% this year and competition for capital becomes an issue

for stocks," Boockvar says.

The stock market's rally from the April lows, the strategist says, has been powered lately by anticipation of "good earnings and a good economy."

Earnings so far have delivered with strong results from the likes of

Apple

(AAPL) - Get Report

and

Advanced Micro Devices

(AMD) - Get Report

last week. And in spite of Citigroup's miss Monday, other companies beat earnings estimates, including

Bank of America

(BAC) - Get Report

and

Schwab

(SCH)

.

Economic indications, likewise, have been upbeat, with rising employment, strong retail sales, positive consumer sentiment and tame inflation. In its latest run-up, the stock market has been feeding on these positives and more of these positives are expected to continue higher.

But those built-in expectations make the market more vulnerable to disappointments. In spite of the S&P 500's breaching four-year highs and the Nasdaq new yearly highs last week, many technicians have been unimpressed with the market's performance, citing an erosion in market breadth even as the major averages were hitting new highs last week.

The arguably vulnerable stock market will have to deal with Greenspan's last semiannual testimony on Wednesday. "That testimony always produces fireworks for the market, one way or another," says Randy Diamond, equities sales trader at Miller Tabak. And this year's being his last, the fireworks could have a more dramatic impact, he says.

The growing consensus is that Greenspan will aim to provide an upbeat assessment of the economy, tainted by caution about housing, both of which will signal that the Fed intends to continue raising rates for the foreseeable future, as hinted at in Greenspan's letter Monday.

According to Miller Tabak, the market is currently pricing in a 100% chance that the Fed will again raise rates at its August meeting and a 84% chance that it will do so again in September. Another rate hike either in November or December, which would bring the Fed funds rate to 4%, is also priced in at 100%.

No wonder that the bond market felt appropriate to sell 10-year bonds, lifting their yields away from 4%. And according to Miller Tabak's Boockvar, Greenspan will likely jawbone the bond market so that yields rise further.

That's especially likely given the Fed's concerns about "froth" in the housing market. The rising yields of the past couple of weeks already have lifted mortgage rates, and the impact on homebuilder optimism has been almost immediate.

The housing sector confidence index fell 2 points to 70 in July, according to the National Association of Home Builders. That's still way above the 50 level, which separates poor and favorable expectations.

Rate concerns have been cast aside by the stock market in recent weeks, but they could return forcefully depending on how much Greenspan is able to jawbone the bond market, and how far 10-year yields rise.

There's still a lot of room to go, even just to get back to "even" for the current tightening cycle. The yield stood around 4.7% a year ago, when the Fed first started raising rates.

To view Aaron Task's video take on today's market, click here

.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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