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Questions over next Fed chief a bigger issue than taper

Douglas Graham | Roll Call | Getty Images

No Larry Summers at the Fed may have triggered a bigger market reaction than the Fed will muster with its own policy statement Wednesday.

The former Treasury Secretary was seen as President Obama's first choice until he dropped out of the running this weekend. Summers was expected to face a difficult, if not impossible confirmation process. Stocks rallied Monday, as traders assumed Fed Vice Chair Janet Yellen would now be named to replace Fed Chairman Ben Bernanke when he leaves at year end. She is viewed as more dovish and more of a consensus builder than Summers.

(Read more: Obama's move to pack the Fed may have hit a snag)

That drove the stock market sharply higher though it closed off its highs. The Dow was up 118 points at 15,494, and the S&P 500 was up 9 at 1697. Traders said short-covering helped push the market higher during morning trading. The yield on the 10-year note declined by more than a tenth of a point but selling pressure sent yields higher later in the day. The 10-year ended the day with a yield of 2.87, slightly off Friday's 2.88 percent.

The Fed, meanwhile, begins its two-day meeting Tuesday, and after weeks of speculation, it is expected Wednesday to announced that it is slashing the amount of its monthly bond purchases to $70 or $75 billion from $85 billion.

It is also expected to cut back more on Treasurys than mortgage-backed securities. Talk of the Fed's policy shift has driven rates higher since May and made for some rocky trading in stocks, but analysts believe a small decrease in Fed bond purchases is priced in, as long as the Fed's tone is dovish on Wednesday.

"We built the Fed up way too much," said James Paulsen, chief investment strategist at Wells Capital Management. "I think it's not the be all, and I do think the market is reacting like that. Almost everybody expects the taper."

Ward McCarthy, chief financial economist at Jefferies, has said he expects the Fed to wait before tapering because the economic data is too inconsistent but he concedes it could move forward Wednesday. The Fed has said it would makes its decision based on the economic data.

(Read more: After Summers, traders betting on 2015 rate hike)

"If indeed , it is data dependent, and not pre-determined, I think it's difficult to make a compelling case to start the ball rolling this week," he said.

McCarthy said the fact that Summers bowed out just adds to an environment of uncertainty. "I don't think this weekend's events resolved anything. It just took us down another path of the Bernanke successor saga," he said, adding President Obama does not have to name Yellen. "The market will be on pins and needles until we finally find out who the next Fed chair is."

Citigroup chief U.S. equities strategist Tobias Levkovich said in a note Monday that the Summers move could unsettle markets. "While Citi's economics team still expects $10-15 billion of tapering, especially given the new-term backup in 10-year Treasury yields, the lack of a choice does generate another level of discomfort. President Obama certainly has other respectable choices for the position, but fund managers value clarity over the absence of a clear appointment," he wrote.

(Read more: Fed may drag bank stocks down in 2013)

The uncertainty about who will run the Fed also lingers in coming weeks when the markets will likely be worrying about Congress passing a continuing resolution to keep the government funded as the fiscal year end approaches. "There really is a leadership void in Washington now. The president is struggling, and it's very clear than neither (Sen. Harry) Reid nor (Rep. John ) Boehner have control of their respective chambers," McCarthy said.

Paulsen said while the seemingly well-broadcast Fed's meeting should not a big event for markets, other things could be in coming weeks, including the Congressional wrangling over the debt ceiling and budget funding.

"You've got all these uncertainties here. I'm wondering if we don't hit an air pocket here," Paulsen said. "Maybe it will be scarier than the last one. That wasn't very scary and it didn't dent sentiment much." He expects the S&P 500 to stay in a range of 1575 to 1725. "I wouldn't be surprised if we break 1600 before the year is out," he said.

(Read more: Fed taper likely to start this week: El-Erian)

McCarthy expects the bond market to trade nervously ahead of the Fed. "I think it will continue to trade jittery. The Summers news forced some position adjustments…The closer you get to an FOMC policy statement, the more jittery he market gets anyway."

On the calendar Tuesday is CPI at 8:30 a.m. ET, Treasury international capital flows at 9 a.m. and the National Association of Home Builders survey at 10 a.m.

—By CNBC's Patti Domm. Follow her 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.

  • 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.