Bullish momentum should drive stocks higher in the week ahead as markets watch to see if Federal Reserve Chairman Ben Bernanke weighs in on whether the economy is strong enough to justify paring back on Fed bond buying any time soon.
The debate about whether and when the Fed should start trimming back on its bond-buying program was underway in markets this past week, and was further fueled by the comments of Fed hawks. It also has made the Fed chairman's economic testimony before the Congressional Joint Economic Committee Wednesday even more important.
"He's got to be a bit of a two-handed economist," said Pimco strategist Tony Crescenzi. "On the one hand, he shows the Fed is concerned about downside risk to growth, and in so doing keeps markets believing the Fed will remain accommodative for a long time, but on the other hand, he has to seem somewhat optimistic about the future because the decision point is getting closer to a taper. Given the rising asset prices and improving employment…he'll say there's been progress."
"I think [Bernanke's] going to have to say something,"said Art Cashin, director of floor operations at UBS. "I don't know how specific he'll be, but he's going to have to address it. The amount of Treasurys coming are shrinking, and the amount of mortgage bonds are shrinking. People are wondering what they're going to do. Even if they want to keep ongoing, they have to change what they're doing."
The Fed currently purchases $85 billion a month in mortgages and Treasury securities, and the market debate this past week has focused on whether the economy is strong enough for it to begin to cut back on those purchases and also how it would do so. The discussion also comes as other central banks around the globe are adding tremendous liquidity, helping send the dollar higher.
Bernanke is the highlight but there are other Fed officials speaking earlier in the week, including Chicago Fed President Charles Evans and New York Fed President William Dudley. They should be more dovish in their comments than the Fed officials who spoke in the past week. Philadelphia Fed President Charles Plosser, who does not vote on policy, said the Fed should start cutting back on its bond purchases in June, and San Francisco Fed President John Williams said the Fed could start winding down this summer, if employment continues to improve.
(Read More: Fed 'Tapering' Talk Getting Louder)
"I remain extremely skeptical that the Fed will do anything to change its posture, probably through the summer. The data is suspect, at best, right now and there's as many negatives in the data set right now as there are positives," said Boris Schlossberg, managing director of foreign-exchange strategy at BK Asset Management. "I think they're definitely going to err on the side of caution. I don't think they're going to change their policy one centimeter for the time being. I think the market is anticipating something that is not about to happen."
The Fed also releases the minutes of its last meeting Wednesday afternoon, and investors are hoping to see more about the Fed's discussions on its easing program. The talk of the Fed "tapering" peppered Wall Street research in the past week. JPMorgan economists said the Fed could begin discussing tapering in June, and carry it out at the end of the year. Meanwhile, Goldman Sachs economists expect it to be discussed in December, and then implemented early next year.
The idea of the Fed paring back on its bond purchases was also advanced after the Congressional Budget Office released estimates for a smaller-than-expected deficit this year of $642 billion, $200 billion less than its previous forecast. The Treasury has already indicated that it may decide in the next several months to issue less debt. Bernanke is expected to speak on the economic outlook before the committee Wednesday morning, but traders expect him to also discuss policy.
Crescenzi said he expects that when the Fed does trim its purchases, it will do so slowly to about $50 billion or $60 billion a month.
"That would still represent fairly substantial easing on an ongoing basis," Crescenzi said. "That's equivalent to about a half-point cut in the Fed-funds rate," he said.
The Fed will likely wait for several months of improved employment numbers before moving to taper, Crescenzi said. "We wouldn't put a high likelihood on tapering June 19, but it's not implausible. There's a scenario where it could happen. If payrolls are stronger, very vigorous and the full report is robust," he said. The next employment report is released June 7, and the Fed meets June 19.
Some analysts say the Fed's tapering of bond purchases should not be a big mover of markets, but the time will come, still several years away, when the Fed increases the Fed funds rate, and that will have an impact.
"If the Fed begins tapering, I don't think it makes a difference," said Dan Greenhaus, chief global strategist at BTIG. "The fact the stock market is higher only because of the Fed I don't agree with. If the budget deficit gets smaller and the economy improves, quantitative easing should be able to get smaller without some macroeconomic disturbance."
Greenhaus expects the Fed to start paring back in the third quarter and end its QE program about a year later.
The Fed has given itself an out if paring back the program hurts the economy. In its last meeting statement, it said it could either increase or decrease the amount of assets it is buying. With the Fed buying Treasurys, it has helped keep rates low but also pushed buyers into riskier assets, adding big support for the stock market.
"If the Fed tapers because the economy is improving, because the jobs numbers are better that would steepen the yield curve, and push yields up across the curve," Crescenzi said. "If it tapers because of costs and risks and it's worried about excess speculation, then it would be cutting off the fuel too soon, and the engine could stall for the economy."
Stocks hiccupped this week when the San Francisco Fed's Williams Thursday said tapering could come this summer, but for the most part, the market steadily moved higher. The Dow was down 42 points Thursday, but for the week, it is up 1.6 percent to a new high of 15,354. The S&P 500 was up 2 percent at 1667. The dollar index was up 1.3 percent, and the 10-year yieldended the week at 1.94 percent.
Andrew Burkly, head of institutional portfolio strategy at Oppenheimer Asset Management, said the market is overbought but could keep going up for now, with cyclical sectors driving it.
(Read More: JPMorgan Goes All-In on Rally; Sees Surge Growing)
"They were the laggards and now they are catching up," he said. Financials were the best performers of the week, up 3.7 percent, followed by industrials, up 2.2 percent. The telecom and utilities sectors, which led the market higher earlier in the year, were the week's laggards, up 0.4 and 1 percent respectively.
Greenhaus said he expects the stock market can continue to move higher, but it's showing signs of wear. "What gives me pause is the fact that the S&P is 12 percent away from its 200-day moving average. That's a stretched valuation," he said.
What Else to Watch
Housing data dominates the economic calendar in the coming week with existing home sales Wednesday and new home sales Thursday. Manufacturing PMI for Europe, the U.S. and China is released Thursday.
There are still a few late quarter earnings reports, including Hewlett-Packard, Toll Brothers, and retailers - Home Depot, Lowe's, Target, TJX and Saks.
The U.S.Treasury also auctions $99 billion in 2-year, 5-year and 7-year notes Tuesday through Thursday.
(Read More: What to Watch in Retail Earnings Next Week)
The Week Ahead Calendar
Earnings: Campbell Soup, Ryanair, Urban Outfitters, TIVO
1:00 pm: Chicago Fed President Charles Evans speaks on the economy
11:30 am: St. Louis Fed President James Bullard speaks in Frankfurt, Germany, on monetary policy
1:00 pm: New York Fed President William Dudley speaks on a panel at Japan Society, N.Y. on policy
1:00 pm: Treasury auctions $35 billion 2-year notes
7:00 am: Mortgage applications
10:00 am: Fed Chairman Ben Bernanke testifies at Joint Economic Committee on economic outlook
10:00 am: Existing home sales
1:00 pm: Treasury auctions $35 billion 5-year notes
2:00 pm: FOMC minutes
Earnings: Toronto Dominion, Advance Auto Parts, Dollar Tree, GameStop, Ralph Lauren, Sears, The Buckle, Gap, Marvell Tech, Ross Stores, Salesforce.com, Mentor Graphics, Pandora, Zumiez, Signet Jewelry
6:05 am: St. Louis Fed's Bullard speaks on economy and policy in London
8:30 am: Weekly jobless claims
8:58 am: Manufacturing PMI
9:00 am: FHFA home prices
10:00 am: New home sales
1:00 pm: Treasury auctions $29 billion 7-year notes
Earnings: Abercrombie and Fitch, Footlocker
8:30 am: Durable goods