Here it comes: Are you ready for the Fed to taper?
Five years after Lehman's failure nearly toppled the financial system, the Federal Reserve is preparing to take a step back from one of the extraordinary programs it launched to save the economy, a move that has been and could continue to be wrenching for markets.
The Federal Reserve is expected to announce its first move to taper its $85 billion in monthly bond buying when its two-day meeting ends Wednesday. While the Fed is seen curbing bond purchases by an initial $10 to $15 billion — a relative baby step compared to the massive amount of stimulus applied — it sends an important message that the Fed is moving toward a normalization of rates and expecting a more normal economy.
"We have come a long way, and we often forget how far we've come. At the heart of the crisis, people didn't think there was a tomorrow. Now we know, there's a tomorrow. We just don't know how strong it is," said Diane Swonk, chief economist at Mesirow Financial. "Sometimes the cure has its own dangers and you have to look at those tradeoffs. That's where the Fed is. Is the cure good enough for the risks?"
The Fed's bond buying, which has ballooned its balance sheet to $3.6 trillion, has been criticized for adding too much easy money to the economy and over-inflating the stock market. Just talk of a pullback in the Fed's quantitative easing program prompted a swift move up in Treasury yields, and also mortgage rates. Stocks reacted negatively at first to the higher rates, but the pain across emerging markets was much more intense as capital took flight. U.S. stocks have largely recovered, with the now just about 1.2 percent from its all-time high.
(Read more: Dow logs its best week since January as traders brace for Fed)
Whither Markets?
Traders believe much of the market moves around this first step in unwinding policy may have already taken place, but there is still concern the actual news could bring a volatile reaction if it doesn't go just right.
"Treasury yields probably went too high on QE 'tapering' talk and will come back down a little bit. I feel like Treasury yields were going up one way or the other. I think stocks could get over it," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi.
"It's all in our minds. It's not liquidity that's buying stocks. It's just a kind of a feel-good for stocks … that the Fed's on the case and doing something. It should not be fueling anything. It did do something originally when stocks were weak and people were starting to look forward to the QE announcements, but I don't think it's going to have the same impact when they pull it away," said Rupkey.
The Fed launched the latest round of quantitative easing in response to worries about the "fiscal cliff," when tax increases and spending cuts were expected to kick in at the end of 2012, and as Europe's sovereign debt crisis flared. While those crises have passed, traders are watching talks in Congress on a budget resolution and the debt ceiling as a new source of potential crisis later this month or next.
While the Fed meeting in the week ahead tops the list, Congressional budget maneuvering and any developments on Syria will also get attention. The United Nations is expected to receive a report Monday which should show if Syria used chemical weapons on its citizens.
One uncertainty was removed about the Fed this weekend: former Treasury Secretary Larry Summers will not be replacing Fed Chairman Ben Bernanke. In a surprise announcement, Summers withdrew his name from the running, and traders now assume the successor will be Vice Chair Janet Yellen. That has sparked a rally in stocks and Treasurys. Summers was seen as the favorite of President Obama, but he was expected to face a tough confirmation process.
(Read more: Will Syria keep Larry Summers out of the Fed?)
If the Fed news Wednesday triggers a move up in rates, or the Fed is not extremely dovish in its comments, stocks could feel some pain. Some economists expect the Fed to reduce Treasury purchases but continue to buy $40 billion in mortgage securities, in an effort to tighten mortgage spreads. Others expect to see mortgage purchases trimmed as well.
"The (stock) market is trading as if Goldilocks is in charge, and the bears may be headed home soon," said Art Cashin, director of floor operations at UBS. "What's priced in is a taper and $10 billion. If it turns out to be mortgages that are reduced, that's not priced in….That's a surprise. Any more than $10 billion is a surprise and volatility can pop back up."
The Dow in the past week was up 3 percent, to 15,376, its second best week of the year. The S&P 500 was up 2 percent at 1687, its best week since July, and the Nasdaq was up 1.7 percent at 3722, despite a 6-percent decline in Apple. The 10-year Treasury was yielding 2.89 percent late Friday, and traders are watching whether it will hit the psychological 3-percent level in the coming week.
Peter Boockvar, chief market analyst at the Lindsay Group said the success of the Treasury's 10-year and 30-year bond auctions this past week shows the bond market has priced in the tapering, but he does not see the same in the stock market.
"I think the stock market is still too nonchalant about this rise in interest rates. We've already seen an immediate reaction to the rise in rates. Everything's not better in the economy," said Boockvar. "I don't agree with the stock market here. The key for next Wednesday is not the $10 to $15 billion. It's how they circle around that with their language. The only weapon the Fed has left in controlling rates is how they jawbone short-term rates."
"They can only rely on verbal, short-term rate jawboning. The market's forced them into that situation. The bond market took control of the long end, and the Fed has gone to plan 'B,'" he said.
Jawboning versus QE
Bernanke is expected to take extra care in communicating the Fed's message Wednesday, keeping in mind it will be for his successor to implement. Besides the Fed statement, the Fed will release new economic and rate forecasts, and Bernanke will hold a media briefing.
Nathan Sheets, global head of international economics at Citigroup, expects a small taper of $10 to $15 billion, and he expects the Fed to transition away from taking policy actions to pressing its forward guidance.
"It will be accompanied by very dovish rhetoric and communication by Bernanke. I think he will say we're slowing the pace of securities purchases but he'll also make it clear it's not a one way street so if the economy slows, they would have the possibility of raising it," Sheets said.
Of big interest to the markets is what the Fed projects in its rate guidance for 2016, which it will forecast for the first time. It has indicated it expects to start raising the Fed funds rate, the Fed's target rate for overnight lending between banks, in 2015. Fed officials have repeatedly assured markets they do not intend to move quicker to raise short-term rates, which affect a whole range of consumer loans and things like credit card rates.
But Bernanke has also said the QE purchases should be finished by the middle of next year, and that at that time unemployment should be about 7 percent. The Fed has also indicated it has targeted an unemployment rate of 6.5 percent for when it would begin to raise short-term rates. So if the Fed expects employment to continue to normalize in 2016, a "normal" level of interest rates – about 4 percent – would be much higher than the market expects.
For that reason, economists expect the Fed to show just a modest hike in rates in 2016, trailing the economy's performance.
"They are, in a sense, being pressed to act at this meeting, and to get tapering started because of some of these quantitative indicators they put down," said Sheets. "They said they wanted to end (QE) at 7 percent. The unemployment rate is already 7.3 percent ... I think what they're going to debate is are these crisp indicators doing what we want them to do or restraining policy. You might see him fuzzing them."
Sheets said the Fed could drop the unemployment-rate threshold from 6.5 percent, as some economists have been expecting. But Bernanke could also talk around that, and highlight the Fed's guidance. "He can say all we've done today is shift the use of tools we're using to provide stimulus," Sheets said.
If the Fed does not taper at this meeting, it is expected to do so soon, and few see the Fed holding back from tapering this fall even though economic data have been spotty.
And even when the Fed does pare back bond purchases, it will still be conducting a program to replace the mortgage securities on its balance sheet as they mature, so there are further purchases of some $20 billion a month. There is also no discussion yet of what might become of what could be the Fed's biggest unconventional tool — its balance sheet.
Sheets said the taper is like the Fed taking its foot off an accelerator. "It's not even looking at braking. They think it's the stock of purchases (on the balance sheet) that's stimulating the economy," he said, adding it's like holding the Fed funds rate at a very low level. "I see these balance-sheet policy and quantitative easing approaches in some ways being intensive care medicine. The policies he put in place were when we were worried about very severe economic outcomes, like the ones we were facing in 2008 and 2009. We now have an economy that is disappointing but this is not an economy that's on the precipice like it was four or five years ago."
What Else to Watch
Housing data tops the economic calendar for markets this week. There is home-builder sentiment data Tuesday, housing starts Wednesday and existing-home sales Thursday. Economists are watching to see if higher rates have had an impact on the housing recovery.
Monday
0830 am Empire state survey
0915 am Industrial production
Tuesday
FOMC meeting begins
0830 am CPI
0900 am Treasury international capital flows data
1000 am National Association of Home Builders survey
Wednesday
0830 am Housing starts
0200 pm FOMC statement/economic forecasts
0230 pm Fed Chairman Ben Bernanke press briefing
Thursday
0830 am Initial jobless claims
0830 am Current account
1000 am Existing home sales
1000 am Philadelphia Fed survey
1000 am Leading indicators
1220 pm Cleveland Fed President Sandra Pianalto
Friday
1230 pm Kansas City Fed President Esther George
1255 pm St. Louis Fed President James Bullard
0145 pm Minneapolis Fed President Narayana Kocherlakota
—By CNBC's Patti Domm. Follow here on Twitter @pattidomm.