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Traders spooked after head fake rally, watching Fed speak

A sharp selloff Tuesday after a day-long rally spooked traders and served as a reminder that the volatility is not over.

"Today's action doesn't instill confidence in the bulls," said Scott Redler, partner with T3Live.com. "This will make the bulls more hesitant about stepping in."

Stocks surged in a head fake rally Tuesday, sending the Dow 441 points higher, before gains were wiped out and the market traded sharply lower into the close. The Dow closed down 204 points Tuesday at 15,666, and has now lost 10.5 percent or 1,844 points in just a week.

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Trader on the floor of the New York Stock Exchange.
Getty Images
Trader on the floor of the New York Stock Exchange.

Some strategists had expected a bounce back after Monday's tumultuous selloff, but had noted it could be temporary. That quickly proved to be the case. Stocks were already heading higher ahead of Tuesday's open but were lifted more after a rate cut and cut in bank reserve requirements by the People's Bank of China after Chinese stocks closed Tuesday.

"Volatility works to the upside and the downside. It's naïve of people to think you could get this bounce off of yesterday's bottom, and not have a retest, or more volatility. I think we're going to see a lot of back and forth volatility. Monday may have been a peak in the VIX, but that doesn't mean the straight ride higher has begun once again," said Julian Emanuel, equity and derivatives strategist at UBS.

Wednesday's markets are expected to take their cue from the action in China overnight. But there will also be plenty of speculation about the Fed and when it might raise rates. New York Fed President William Dudley speaks to the press on the regional economy before taking questions at a 10 a.m. ET event. Dudley speaks ahead of the Jackson Hole Fed symposium at the end of the week, where Fed Vice Chair Stanley Fischer will address the group Saturday.

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"He's (Dudley) a wild card," said Chris Rupkey, chief financial economist at Bank of Tokyo Mitsubishi. Dudley is viewed as dovish and close in thinking to Fed Chair Janet Yellen but Rupkey said he sounded a bit more hawkish recently. "He's said some aggressive things that people noted … like if market yields don't go up when they raise rates, they may have to raise rates higher."

Redler said the market wants to embrace good news on the economy, and traders don't want to worry about when the Fed will raise rates. Both J.P. Morgan and Citigroup Tuesday reaffirmed their view that September is more likely for a rate hike, but they also noted financial conditions and China could weigh on the Fed's thinking. Barclays Monday pushed back its expectations for the first Fed hike to March.

"This China issue is a very real issue. It is exporting deflation. I think itt's going to prevent the Fed from raising rates. I think today, a big part of the decline was the Fed," said Wedbush Securities Managing Director Steve Massocca. He said the market is worried the Fed may feel compelled to raise rates because of strong enough U.S. data even with what is going on in China.

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"The market probably doesn't even know what it wants to hear form Dudley," said Redler, adding the market seems to want to see good news on the economy. "Consumer sentiment was a good number…. I don't think anyone expected this kind of rollover this fast." Consumer confidence rose Tuesday to its highest level since January.

Durable goods are reported Wednesday at 8:30 a.m. ET, and they are expected to be up 0.1 percent, down from the 3.4 percent gain last month.

Rupkey expects to see some improvement in business spending in the data. "I'm keeping my fingers crossed for a stronger number," he said.

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The market selloff has sharpened the debate about Fed rate hikes. "I think economists are panicking with the market, as well. It just depends on what side of the fence you are on," Rupkey said. "There's a very political battle going on…. You just got today that five of the 12 (Fed) districts at the July meeting wanted to hike rates. Five of them wanted to raise the discount rate."

The S&P 500 fell 25 points Tuesday to 1,867. The S&P has now lost $2 trillion in market cap since the beginning of last week, according to CNBC's breaking news desk.

But Redler says it could now test Monday's lows. "1,831 was Monday's low. That's what traders will be eyeing if there's a down open," said Redler. "Traders will have to have two game plans tomorrow…. If we gap up, we now have to find a new defined range close to 1,950, which is where we'll see what type of strength there is or there isn't."

Read MorePoll: Did today's late selloff change your market view?

As stocks sold off, bond yields gave up some gains. The 10-year was at 2.07 percent in late trading after rising to 2.13 percent.

There is also a $35 billion 10-year note auction at 1 p.m. ET.