The shrinking federal budget deficit and spotty improvement in the economy has turned talk on Wall Street to the idea that Fed will start planning to "taper" back its bond buying activity.
Wall Street has treated the Fed's quantitative easing progam as a security blanket, and stock investors have seen it as fuel for the market's rise but also as a safety net.
Tapering, or a gradual reduction in the Fed's monthly $85 billion Treasury and mortgage purchases, is expected to be months away. But bond traders are chatting about it more as a reality now, than they were just a few weeks ago when the economy looked a bit worse.
"We're now in an environment where the market can smell the end of QE coming up, or at least a tapering," said Deutsche Bank G-10 currency strategist Alan Ruskin. "They can see a market where bond yields are higher."
At the same time, rates are rising, the dollar is stronger and equities have been rising—an unusual trading dynamic in the post-financial crisis years. It's a sign to some of increased confidence that the economy is improving. But it's also a sign that China's weakness, lack of growth in Europe and interest rate volatility in the Japanese bond market may be sending investors to the dollar and U.S. assets.
Treasury rates have been moving higher since May 3, when the better-than-expected April jobs report helped lift yields off the year's lows and send them on an upward trajectory. A better retail sales report and improving jobless claims have also supported higher rates, the dollar and equities. While claims rose unexpectedly this week - to 360,000 - the four-week trend is still the best in years.
Other data, like Wednesday's decline in industrial production, and the contraction in activity in the latest Philadelphia Fed survey Thursday, are less positive.
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"We're at the turn of the cycle here, so rates are more likely to go up than down," said BlackRock Managing Director Peter Fisher. "There's an asymmetry to your fixed-income bond portfolio. We recognize that but don't think it [tapering] will all happen in the same week, the same month and maybe even the same year."
In an interview on "Power Lunch", Fisher said that the Fed may start to taper late this year, depending on the economy.
"I thought when the Fed was running $85 billion a month and kept it going after the first of the year, then they were going to wait to see what the sequester did," he said. "Now they've been waiting to see what second-quarter growth looks like. That's the only way they will really know what the sequester did. That's the first time they're going to be able to make a strong conclusion about ... tapering, when they get a good read on Q2 growth.
"I think sometime in the summer or fall ... they might start the taper," Fisher said. "That's the earliest, but if the economy is not doing very well, clearly they left themselves the opening of whether to speed it up or slow it down."
Hedge fund manager David Tepper also discussed the Fed tapering its purchases on "Squawk Box" Tuesday. Tepper said investors should not fear a pullback by the Fed, and that he remains bullish on stocks. His comments helped spark a market rally.
Also adding fuel to the "tapering" discussion was Tuesday's report from the Congressional Budget Office showing that the federal deficit had narrowed more than expected. The deficit has been more than $1 trillion a year for the past four years but is now running at $642 billion for the fiscal year ending Sept. 30, according to the CBO. That would be just four percent of the nation's annual output, and the CBO said it could shrink to 2.1 percent of GDP by 2015.
Three months ago, the CBO forecast that the deficit would be $845 billion, or about 5.3 percent of economic output, but higher taxes and spending cuts have reduced it more quickly. In recognition of that, the Treasury said in its last quarterly refunding announcement that it could reduce issuance in coming months.
That put the focus on the Fed, which is buying $40 billion in Treasury securities every month.
"A big part of the improvement you see in 2013 is $200 billion of that is basically once-off stuff, but we have expected and continue to expect in the next five years the trend in the deficit to improve," said Michael Feroli, JPMorgan's chief U.S. economist. "You're going to get cyclical improvement," he said, adding that longer-term issues have not been addressed.
Feroli said he expects the Fed to begin tapering in December. However, it could begin to communicate more about it as early as its June meeting and is likely to refer to it in the minutes of its last meeting, which will be released next Wednesday.
Markets had been taking the recent talk of tapering in stride, but comments from San Francisco Fed President John Williams late Thursday sent stocks slightly lower, boosted the dollar and sent bond yields slightly higher. Williams, a non voter, said the Fed should begin tapering in the summer, if the job market is strong enough, a position that is more aggressive than traders expect.
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Earlier Thursday, Philadelphia Fed President Charles Plosser, who does not vote on policy this year, reiterated his view that the Fed should start to taper next month.
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JPMorgan economists wrote in a note Wednesday that they do not expect tapering to result in tightening of financial conditions. They also said that concerns that it could trigger the kind of tightening that occurred when the Fed raised rates in 1994 are unwarranted, as conditions are far different and the Fed has been communicating openly.
Feroli said he imagines the Fed might take two swipes at reducing its purchases before stopping them altogether. Rates will be higher once purchases are pared back.
"This is going to happen if data continues to come in well, and jobs numbers come in good, and the bond market will react, and I think it will probably be there by the time the Fed starts to taper. Rates will be higher than where are ," he said. As for stocks, "they're going to be tapering because the economy is going to do presumably better. I think stocks can handle it if the economy is doing better."
Another reason the market is talking tapering: An article in The Wall Street Journal last weekend said the Fed was planning its exit strategy. It quoted Fed officials as saying they plan to reduce the amount of bonds they are buying in "careful and potentially halting steps," varying purchases as their confidence about the "job market and inflation evolves."
The article also said timing was still being discussed. The story followed rumors several days earlier that a Journal article on tapering was in the offing—talk that jolted stocks.
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Art Cashin, UBS director of floor operations, said the Fed—not just the Journal—needs to talk about tapering.
"What I'm looking for at some point, the Fed is going to have to talk about it, not just the tapering—the fact that there are fewer mortgage bonds, fewer Treasury bonds." The Fed must respond to the fact that it still plans to buy $85 billion securities a month in what looks to be a smaller pool, he said.
Tapering is just a first step, and unwinding programs is expected to take years, particularly since the Fed may hold many of the securities on its balance sheet.
David Ader, CRT Capital chief Treasury strategist, said it's far from definite that the Fed is going to reduce purchases this year but that tapering will have an impact when it happens.
"It's a dark area. … We're right in the middle and on the margin of which way this thing can swing," he said. "I don't think we are talking about it with more intent today.
"Tapering is just easing the pace of the accommodation in the system, as opposed to tightening and trying to slow things down," Ader said. "They are still trying to keep things easy, and that in itself is important."
The 10-year yield, at 1.94 percent Wednesday, will likely move in a range of between 1.70 and 1.75 perceny and 2.0 and 2.05 percent for the next few weeks, Ader said.
"Tapering of QE is going to impact the long end, and in that respect, the Fed is going to be much more sensitive to its influence on mortgages," he said.