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Fed message to markets: Don't fear the taper

Pete Marovich | Bloomberg | Getty Images

The Fed's message Wednesday is likely to be a dovish one, but it could still rock markets.

Just as the Fed has its internal divide, the Street is divided about what the Fed's tone might be in the minutes of its August meeting, due to be released at 2 p.m. ET. 'Tapering' of its $85 billion monthly bond purchases has been discussed for months now, driving interest rates higher. Those higher yields have weighed on stocks and are making stock traders nervous.

Some Fed watchers believe the Fed will be ready to slow bond purchases by its September meeting, but others disagree. The bond market selloff has sent 10-year yields as high as 2.9 percent just this week. The 10-year was at 2.82 percent Tuesday, and stocks were mixed after four days of losses. The S&P rose 6 to 1652, and the Dow was off 7 at 15,002.

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"If anything, these minutes are going to cause more problems, more consternation in the market," said Deutsche Bank chief U.S. economist Joseph LaVorgna. "I think there will still be a tremendous amount of confusion. Nothing's going to be settled. This is the problem with transparency. You're forced to comment constantly on things you might not know a lot about."

The Fed minutes are released a day before the Fed's annual symposium gets underway in Jackson Hole, Wyo. In a break with tradition, Fed Chairman Ben Bernanke will not be attending the conference, so there is not the expectation for a major new policy message from the Fed.

However, there will be plenty of Fed voices as a number of regional Fed presidents and officials will be attending, including Vice Chair Janet Yellen.

Yellen is the leading internal candidate to replace Bernanke when his term ends in December, but she is no longer viewed as the clear successor since former Treasury Secretary Larry Summers has emerged as a strong candidate. Yellen is participating in a panel in Jackson Hole but is not making a keynote address.

(Read more: Fed: Banks not planning for worst)

But as for the minutes, Fed watchers disagree on how much detail will be provided. They do say, however, that it will be clear Fed officials are split on how and when to pull back from quantitative easing.

"I'm thinking there will be some discussion of logistics related to tapering," said Ward McCarthy, chief financial economist at Jefferies. "I think it will be broad and general . I don't think the markets seems to be on edge that the minutes will show the Fed is ready to pull the trigger, and obviously in July they were not ready to pull the trigger, so I think that's premature."

McCarthy said the Fed could announce a slowdown of purchases in October, at earliest because it will need more economic data to make a decision. The Oct. 30 meeting date is the same day the third quarter GDP is released. He also said that, as suggested by St. Louis Fed President James Bullard, the Fed could add briefings after all of its meetings to give it more flexibility to explain policy changes other than just four times a year. As of now, there is no briefing scheduled for October.

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"This set of minutes should have something for everyone. This could really be interesting because they clearly tried to talk the market down following the June FOMC meeting to no success," said LaVorgna. "I would not be surprised if somewhere in the minutes they talk about the market reaction…They'll talk about financial conditions tightening, and that being a bad thing. and they'll reinforce that tapering is not a tightening. There's definitely going to be some dovishness in the minutes."

Robert Sinche, global head of FX strategy with Pierpont Securities, said the Fed will likely show that it's moving toward a September tapering though it won't explicitly say it. "I think they just keep telling the story that things are modestly improving and maintaining their flexibility for the case for tapering in September," he said. "They probably don't want to say anything too committal but sort of quietly steadily laying out the case for scaling back their participation in the market. From our perspective, it isn't that they need good data to taper, they just need to avoid really bad data to taper."

Economists at J.P. Morgan and Goldman Sachs say the Fed could detail how it might change the composition of its bond purchases, signaling it will pare back more of its $40 billion in Treasury purchases than its purchases of mortgage-backed securities. Buying mortgages is seen as having a bigger direct impact on rates, and the Fed fears a recent run up in mortgage rates will hurt the housing recovery. Existing home sales for August are also reported Wednesday, at 8:30 a.m.

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Other economists disagree and expect the Fed to continue buying near equal amounts of Treasurys and mortgages.

The Fed could also change what it has said about forward rates guidance. McCarthy said the Fed could change the threshold for raising short term rates from 6.5 percent unemployment to 6 percent unemployment. The Fed is not expected to move on short term rates until 2015, and it has attempted to soothe market concerns that once it starts paring back bond purchases it is getting close to raising rates. Unemployment has also been moving down, and was 7.4 percent in July, even as the economy continues to grow slowly.

Besides the Fed, there are earnings reports expected Wednesday from Target, JM Smucker, Lowe's, PetSmart, Toll Brothers, Staples, American Eagle, Madison Square Garden and Eaton Vance, ahead of the opening bell. Hewlett-Packard, Hains Celestial andLBrands report after the close.

—By CNBC's Patti Domm. Follow here on Twitter @pattidomm.

  • 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.

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

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