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Fed May Not Be Able to Tame Volatile Trading

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Whatever Federal Reserve Chairman Ben Bernanke says Wednesday afternoon threatens to rock some part of the financial markets.

"That's how I see it. Tomorrow is dangerous," said Art Cashin, director of NYSE floor operations at UBS.

Financial markets always watch the Fed, and they always hang on every word of Fed policy. But the Fed's post-meeting statement or comments from the Fed chairman Wednesday will either give credence to or conflict with a recent fundamental shift in market perception – and that is that there will be a slow creep to higher rates as the Fed slows and then ultimately ends its bond purchase program.

After weeks of speculation about whether the Fed will or will not clarify its position on quantitative easing, traders are handicapping the outcome of the Fed's two-day meeting and are looking for more guidance on when the Fed could begin what is mostly expected to be a slow paring back of its monthly purchases of Treasurys and mortgage securities.

(Read More: Markets More Doubtful on Benefits of Fed Easing: CNBC Survey)

The meeting ends Wednesday with a 2 p.m. ET statement and revised economic forecast, and is then followed at 2:30 p.m. with a briefing from the Fed chairman.

"We went from QE forever to QE finite. It's the timing that is uncertain," said RBS senior Treasury strategist John Briggs.

Another wrinkle that added to market confusion Tuesday was a comment from President Obama, who basically confirmed market expectations that Bernanke will leave at the end of his term in January. In an interview with Charlie Rose, Obama said the Fed chairman "already stayed a lot longer than he wanted or he was supposed to."

(Read More: Obama 'Essentially Fired' Bernanke: Meyer)

Fed Vice Chair Janet Yellen is widely seen as the leading candidate to replace him, but there are other possibilities, including former Treasury Secretary Larry Summers. Yellen's views are seen as similar to Bernanke's.

Stocks have staged a two-day melt-up rally ahead of the Fed's Wednesday statement, on the idea that Bernanke will not signal an abrupt end to the $85 billion a month bond purchasing program. But Cashin said bond yields rose early in the day Tuesday, as traders in that market speculated the Fed could be a bit more aggressive in its talk of "tapering" the purchases. The 10-year was yielding 2.19 percent in afternoon trading, slightly higher than Monday.

"Gold is down and they're also worried that the slightly tapering could lift rates a little bit which would kill what little inflation there is," Cashin said. Gold lost 1.2 percent Tuesday, falling to $1,366.90 per troy ounce. Cashin said the stock market seems to have accepted the view of slight tapering.

"Each (market) seems to see through (its) own eyes rather than universal appraisal and reaction. That could make tomorrow afternoon quite volatile," he said in a note.

(Read More: Likely Candidates to Succeed Bernanke)

The Fed's quantitative easing program has been a security blanket for financial markets, pushing stocks higher and pacifying the bond market. But the idea that it is slowing has added an edge of uncertainty, and a lot of volatility to financial markets. While it could end QE, the Fed is not expected to raise the Fed funds target rate from its current zero level until 2015.

"I think the message is going to be adjustments to the QE program going forward are possible, potentially in the next several meetings, which could be three to five meetings if the data continues to improve," said Briggs. "People are pretty split between it happening in September or December, so him saying it might happen over the next couple of meetings doesn't scare me."

Stocks could continue to rise in this scenario, Briggs said."If Bernanke has his way and we have this slowly rising rate path, and the economy continues to grow, I think they can," he said. Briggs said the 10-year yield, at 1.62 percent May 2 before it started rising, should stay above 2 percent but not yet get to 2.4 percent, a post-financial crisis high.

"I think a lot of it is priced in unless we've been reading the tea leaves wrong. There was a need for a readjustment that's taken place in a lot of these markets, and (foreign exchange) markets. The stock market is acting like he's going to be dovish," said George Goncalves, Treasury strategist at Nomura Americas. "They're going to be thoughtful not to allow people to rush to judgments. If they strike the right balance, it's not imminent. It should be slightly more dovish than we are now. The stock market is looking through it because he's not going to be hawkish. I share that view. Now is not the time to be hawkish. We haven't turned the corner yet."

Goncalves said the Fed could begin to taper back by the end of the year, but it will base its decision on the improvement in the economy. He said it would be helpful if the Fed would emphasize that even if it ends the QE program, it does not plan to raise short-term rates.

Some economists believe there's room for the Fed to downgrade its view of the economy slightly, and trim its inflation view. Fed officials see the economy growing this year between 2.3 and 2.8 percent. Nomura economists, however, also see a chance the Fed could raise its forecast if officials expect more improvement toward the end of the year.

"The market's going to care about whether they are changing something dramatically enough that I should worry about the next six weeks of trading. I don't think they will," Goncalves said. "I can see it being very polished.The (question and answer) is going to be where all the fireworks are going to be. The statement's going to be balanced."

Deutsche Bank Chief U.S. economist Joseph LaVorgna said the Fed's own comments have confused the markets, and despite the move to be more transparent, the Fed's message hasn't been clear. He also noted that the Fed's last meeting statement did not show the disagreement among committee members that was evident weeks later when the minutes of the last meeting were released.

Some Fed officials have said they believe the Fed should move to pare back purchases sooner rather than later, and even Bernanke said he thought the Fed could decide to trim purchases in the the next couple of meetings if the economy is strong enough.

"I would love it if they are more aggressive then I think they're going to be. I don't think they're going to tell us anything the market's not expecting," he said. "I think Bernanke has gone too far in easing and in terms of quantifying its impact, it's not that positive for the economy.Taper does not mean tightening. This is a slowdown in the pace of accommodation, so they're still easing at a slower pace."

LaVorgna said the bond market's reaction Wednesday is key. "If the bond market hears something it doesn't like, it could be a two-step move for equities," he said. For instance, equities could move immediately higher if there is less talk of tapering, or even if the economic view is downgraded, but then the market could move lower again because it would signal a slower economy.

"How do you meld all these desperate views?" LaVorgna said. "He's probably not going to be able to say a whole lot because he's got to speak for the committee. I don't mean to be pejorative, but he'll end up speaking out of both sides of his mouth."

Before the Fed statement, Japan Prime Minister Shinzo Abe speaks in London at 1 p.m. ET on his economic program, a topic that could also add to volatility.

FedEx earnings are released ahead fo the bell, and Micron reports after the close.

Mortgage applications are released at 7 a.m., and oil inventory data is released at 10:30 a.m.

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC Senior Commodities Correspondent and Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.