Despite Friday's rally, which ended three days of heavy losses, analysts foresee economic data pushing the market down.
"We've got a lot of economic data next week and that will set the tone," said Owen Fitzpatrick, head of the U.S. equity group at Deutsche Bank. "The trend lately has been pointing to a stronger economy, which means interest rates might continue to rise."
Bond prices tend to fall, sending yields higher, when strong economic reports boost inflationary pressures. Inflation erodes the value of fixed-income assets such as bonds.
Further rises in bond yields?
Concerns about rising interest rates globally have rocked the market over the past week. In the U.S., the benchmark 10-year Treasury bond fell sharply in price, sending its yield to above 5% for the first time in almost a year.
Higher yields boost the attraction of risk-free government bonds compared to stocks, while also raising borrowing costs for businesses and consumers. The 10-year bond yield is used to benchmark most consumer interest rates, including mortgage rates.
"We have to keep an eye on yields going forward," said Kevin Kruszenski, head of trading at KeyBanc Capital. "If they continue to move higher, that may still take more enthusiasm out of stocks."
Amid those concerns, the first week of June began on a sour note for stocks. The Dow Jones Industrial Average lost 1.8%, the S&P 500 index fell 1.9%, while the Nasdaq Composite dipped 1.5%.
The hardest hit among blue chips this week were financial stocks such as American Express , Citigroup Inc. and JP Morgan Chase & Co. .
Meanwhile, consumer-related issues such as Wal-Mart Stores Inc. , McDonald's Corp. and General Motors Corp. managed to squeeze out some gains.
A rally on Friday helped the market recover some ground, as bond yields seemed to stabilize and crude oil prices stumbled more than 3%. The Dow gained almost 158 points, the S&P rose 1.1% and the Nasdaq gained 1.2%. .
"But it will be hard to sustain a recovery until we get an idea of where interest rates settle," said Mike Malone, trading analyst at Cowen & Co. "My expectations are that the market will remain volatile in the near term."
Adding to the uncertainty, next week brings the expiration of options, which allow investors to bet either on a rise or a drop in stocks. Options expirations are typically associated with high volatility in the market.
May import prices and retail sales, as well as the Federal Reserve's Beige Book of economic conditions, are all due to be released on Wednesday. But even more crucial will be producer and consumer prices reports for May, which will be released on Thursday and Friday, respectively.
"The inflation data will be of primary importance," said Cowen's Malone.
After U.S. economic growth slumped to 0.6% in the first quarter, many strategists now point to recent data as signaling a rebound in the second quarter. The data has led central bankers, including Fed Chairman Ben Bernanke, to maintain a hawkish outlook on inflation.
The market has drastically reduced its bets that the Fed will cut interest rates later this year, while market odds that the Fed will hike rates have increased, a negative trend for stocks.
Many strategists noted that the rise in bond yields was a global phenomenon, with many central banks around the world lifting interest rates recently. Over the past week, both the European Central Bank and the Reserve Bank of New Zealand hiked interest rates.
"We have to look at what's happening globally to figure domestic interest rates," said Malone. "We hava liquidity-driven economy and markets. If interest rates rise and liquidity were to be sucked out of the global economy, that would put downward pressure across a broad spectrum of asset classes."
"We've had such a sharp rise that we were due for a pause," said Deutsche Bank's Fitzpatrick. "But those pull-backs don't tend to last just a few days."
The Friday rally, he noted, came on the back of an abrupt three-day sell-off, which usually leads to a short-lived bounce.
Other analysts, such as Peter Cardillo, chief market economist at Avalon Partners, believe the market is due for a correction of at least another 3%. He told MarketWatch that he's not looking for a "plunge," but rather an orderly decline.
Brokers to post strong quarter
Among the mitigating factors that may still help stocks next week, U.S. broker/dealers Goldman Sachs , Lehman Brothers and Bear Stearns are all expected to post strong quarterly results. Financial stocks tend to provide strong support for the broad market.
"Their numbers should be really, really good," said Deutsche Bank's Fitzpatrick. "They closed their books at the end of May, before the June troubles, and they've seen record [mergers and acquisition] activity, and their trading desks have been doing well."
In addition, the Apple Worldwide Developers Conference might lift sentiment not only for host Apple Inc. but also for the whole technology sector, analysts said.
By Nick Godt