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Why Fed could rock market no matter what it does

Traders on the floor of the New York Stock Exchange
Scott Eells | Bloomberg | Getty Images
Traders on the floor of the New York Stock Exchange

No matter what the Federal Reserve does, traders expect a volatile week ahead.

At its meeting Tuesday and Wednesday, the Fed is expected to discuss removing some of the extreme stimulus it has provided because the economy is improving and its continuous asset purchases may no longer be helping. Whether it acts to slow those purchases is yet to be seen, but that Fed watchers and traders are so widely divided on what it may do raises the odds for a volatile market reaction.

"The fact the Fed blindsided everyone in September makes it more likely we'll have a volatile reaction because nobody's going to have a large bias or position ahead of this," said Ian Lyngen, senior Treasury strategist at CRT Capital. If the Fed announces tapering, he expects a quick, temporary move up in the 10-year yield to above 3 percent.

BTIG Managing Director Patrick Boyle said stocks could rally hard if the Fed does nothing, as he expects, but would sell off if it acts.

"They'll hammer all the markets. Equities would fare a bit better because they seem to be the belle of the ball over the last year versus bonds," he said.

Volatility should continue into the end of the week, ahead of Friday's quadruple expiration of futures and options, and a rebalancing in the Nasdaq and S&P 500. Facebook goes into the S&P 500 that day.

"There is definitely a little bit of profit-taking going into next week," said Boyle, who trades retail and consumer stocks. "This is the first time we've seen the market take a little bit of a pullback in a while, and it's not a bad thing."

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CNBC's Steve Liesman reported that it's likely the Fed will announce a tapering move this Wednesday, while some economists say it has a 50-50 chance. Many traders, however, believe the Fed could use its statement or post-meeting press briefing to lay out a vague promise of tapering and act early next year to reduce its $85 billion-a-month bond purchases.

"I don't think the Fed is going to taper this month. I don't think we've seen enough preparation," said Stephen Stanley, chief economist at Pierpont Securities. "There's been bits and pieces of whispers here and there but currently not the type of preparation that was given to the market ahead of the September meeting."

The Fed had primed markets for a move in September but deferred the decision, saying it was concerned in part by the potential of a negative fiscal impact on the economy. By Oct. 1, the Fed looked justified, as congressional bickering led to a government shutdown. But with that a new budget agreement in Washington, the way is clear for the Fed to act if it believes the economy is strong enough.

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But Stanley said a move next week is especially unlikely because of the end-of-year timing.

"The timing is uniquely bad," he said. "I think liquidity is going to be terrible in the period after the 18th, and economically you're going to be in the heat of the shopping season. For all those reasons, they're not likely to go this month, but they're certainly a lot closer to meeting their requirements for tapering today than they were a month ago."

Besides the Fed, there are three Treasury auctions for $96 billion in 2-, 5- and 7-year notes Tuesday to Thursday. There is also an active economic calendar, including existing home sales and leading indicators. Earnings are expected from FedEx and Oracle on Wednesday, and Nike on Thursday.

Whither Stocks?

In the past week, stocks sold off with the S&P 500 off 1.7 percent for the week, to 1,775, its worst week since Aug. 30. The Dow was slightly positive Friday but down for the week, losing 1.7 percent to 15,755. The Nasdaq was off 1.5 percent at 4,000, and the Russell 2000 was off more than 2 percent at 1,107.

While some strategists expect the beginning of Fed tapering to jolt stocks, Jeff Mortimer of BNY Mellon Wealth Management sees it playing out more positively. Mortimer, director of investment strategy, expects the Fed to start tapering at its March meeting.

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"We've certainly had a pullback in the last few days as the mentions ... and possibility of tapering increased," he said. "This does not scare us away. Tapering could be a good thing if it's backed by good economic data, and if the Fed does ratchet down QE3 … if the economy gives them cover to do so, that's the best outcome."

Mortimer said he is positive on the market for next year, too, and sees the S&P 500 reaching 1,900 to 1,950, and the 10-year Treasury yield possibly touching 3.5 percent.

"The one thing that has our attention here is that there might be a little too much complacency in here," he said. "You have bull-to-bear ratios that are a little stretched and have previously been precursors to pullbacks. I'm not good at saying what was going to happen for the next 17 days. I think we chop a little but stay near these levels."

Mortimer added there could be some selling in January as investors who delayed selling for tax purposes take gains.

Mortimer said the wild card for 2014 is inflation, which has all but disappeared and is also clearly a concern to the Fed. "That is the most important variable. It influences all asset class returns," he said. "It's a lynch pin...We've had disinflation."

Energy is one area that he thinks could be a "white swan," though the economic benefits from increased U.S. drilling of oil and gas is not easily measured. "It's a good thing to have happening in the background," he said.

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Mortimer still sees value in the stock market at these levels, despite the strong gains this year.

"Markets are behaving like they've always behaved, so I'm not surprised that I think next year is another very good year. The only thing that does bother me a bit is that I wish people were celebrating more. We've had an up 25 percent year, and nobody cares," he said.

Monday

Federal Reserve celebrates 100th anniversary

8:30 a.m. Empire State survey

8:58 a.m. Manufacturing PMI

9:00 a.m. Treasury international capital data

9:15 a.m. Industrial production

2:00 a.m. Fed Chairman Ben Bernanke comments at Fed Centennial commemoration

Tuesday

2-day FOMC meeting begins

Earnings: Jabil Circuit, FactSet, Sanderson Farms, Verifone

8:30 a.m. CPI

8:30 a.m. Current account

10:00 a.m. NAHB survey

1:00 p.m. $32 billion 2-year note auction

Wednesday

Earnings: FedEx, General Mills, Lennar, Oracle, Jabil Circuit, Paychex, Herman Miller, Steelcase

7:00 a.m. Mortgage applications

8:30 a.m. Housing starts

10:30 a.m. EIA oil/gas inventory data

11:30 a.m. $35 billion 5-year note auction

2:00 p.m. FOMC statement

2:30 p.m. Fed Chairman Ben Bernanke press briefing

Thursday

Earnings: Nike, Red Hat, Darden, Accenture, Rite-Aid, Worthington Industries, Tibco Software

8:30 a.m. Initial claims

10:00 a.m. Existing homes

10:00 a.m. Philadelphia Fed survey

10:00 a.m. Leading indicators

10:30 a.m. Natural gas inventories

1:00 p.m. $29 billion 7-year note auction

Friday

Earnings: BlackBerry, Carmax, Walgreen

8:30 a.m. Real GDP Q3 final

—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.

  • CNBC's Senior 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.