Dovish or hawkish? Fed message could get markets flying

Dove and Hawk
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Dove and Hawk

The annual Federal Reserve gathering in Jackson Hole and the minutes of the last Fed meeting could keep markets volatile in the coming week, as traders watch for signs of when the central bank might curb its bond-buying program.

The Fed's plans to "taper" or slow down quantitative easing, or bond purchases, has been the talk of markets for weeks, since the Fed said it expected to begin the process before year end. As it gets closer to September, when many believe the Fed may start, taper talk has been sending waves through thin late summer markets. Some better economic reports in the past week helped send Treasury yields zipping to fresh two-year highs on expectations that the economic news will be good enough for the Fed to begin reducing purchases.

While there is no official policy meeting until mid-September, Fed watchers will be dissecting Wednesday's release of minutes from the August Federal Open Market Committee meeting for clues on how and when the wind down of the $85 billion in monthly bond purchases could occur.

The annual Kansas City Fed gathering in Jackson Hole starts Thursday, and while Fed Chairman Ben Bernanke will not be there, other officials will be, and they are bound to continue to express their views on Fed policy. The chairman has used the Jackson Hole podium to launch important ideas about policy.

"There won't be anyone trying to deliver a message on his behalf or for the committee," said Pimco strategist and portfolio manager Tony Crescenzi. "It will be just like many howling wolves in the wilderness — Many voices all over, but the alpha male won't be there!"

Paul Richards of UBS said news-hungry markets will probably still find something to latch on to from Jackson Hole. "I don't think you can get a bunch of central bankers together, and not get something out of it," said Richards, managing director and head of foreign-exchange distribution Americas at UBS. Richards said the quick move higher in yields may give the Fed some pause, and he now thinks there's just a 45 to 50 percent chance the Fed starts "tapering" in September.

The Fed has said it would base its decision on the strength of the economy but also on financial conditions. "I think that's what the market missed," he said, pointing to the effect of higher yields. For instance, the rate for the 30-year mortgage this week was 4.4 percent, more than a full point above where it was in early May.

Stocks in the past week wobbled, and the Dow's 2.2 percent decline to 15,082 was its worst weekly performance in more than a year. Rising interest rates were the biggest culprit. The 10-year Treasury was yielding 2.832 percent late Friday, after making an intraday move to 2.86. The week earlier, it was yielding 2.58 percent.

(Read more: Stocks log 3-day losing streak; Dow posts worst week in 2013)

"There are a few earnings, but I think it's mostly about the Fed. It's also about the housing data we get. We'll get leading indicators and of course, another initial claims, but people will be pouring over the notes from the Fed for the July meeting," said Stuart Freeman, chief equity strategist at Wells Fargo Advisors. Retailers Home Depot, Target and Lowe's report, as do Hewlett-Packard and Toll Brothers.

Hawks or Doves?

While traders are hoping the August meeting minutes will reveal which Fed officials' voices prevailed — hawks, who may want to move more quickly on ending QE — or doves, who would move slower. This past week, St. Louis Fed President James Bullard, a voting member, and Atlanta Fed President Dennis Lockhart, non-voting, both said the Fed may not have enough data to decide on tapering in September.

(Read more: Bernanke may delay tapering past September: UBS)

Bruce Kasman, J.P. Morgan chief economist, said the Fed has been priming the markets for tapering, and it likely will decide to taper in September in the amount of $15 to $20 billion a month. "It's hard to step away from that now," he said.

"I think they do look at what's happening as a tightening of financial conditions…The rise in mortgage rates concerns them. I think it does cut both ways," he said, noting tightening of conditions raises concerns about the Fed's growth outlook. "It also is a signal of how much QE and guidance has pushed financial conditions in a way that you have to be a little concerned about as you move to normalize rates."

Kasman said it's likely the Fed's meeting minutes will help clarify some of their positions, and he expects to see discussion of whether the Fed intends to wind down purchases of both Treasurys and mortgage-backed securities. "We think they're going to be asymmetrical at the start and only do Treasurys. I think we'll get some idea of how ready they are to begin in September," he said.

Crescenzi said he thinks the Fed will cut back on its mortgage and Treasury purchases equally. One reason some believe the Fed would trim mortgages is because of the dwindling amount of new supply.

"The MBS (mortgage-backed securities) purchases have the greater impact on markets than the Treasury purchases because it's a spread product and credit instrument. It's probably going to be 50/50 but the Fed may lean toward cutting Treasurys more," he said. "The Fed's absorbing 65 percent of mortgage-backed securities origination…It was 45 percent leading up to May, then rates went up and refinancings plunged."

The Fed could start paring back with a reduction of $20 or $25 billion, and do that three times, before finally winding down the remainder, he said.

Crescenzi said he doesn't expect Fed officials attending Jackson Hole to make much news this year. "What Steve Liesman garners from the hallways and fishing boats will be more interesting than the speeches themselves," said Crescenzi. Liemsan, senior economic correspondent for CNBC, will be covering the event.

Crescenzi also said Bernanke's resignation letter could be submitted by the end of the month, since President Obama has said he would make a decision on a replacement this fall.

Candidates to replace him are Fed Vice Chair Janet Yellen, a Wall Street favorite who was seen as the clear frontrunner until about a month ago when former Treasury Secretary Larry Summers emerged as a candidate. The succession will certainly be the unofficial talk of Jackson Hole, and it will continue to be a focus in the markets. Yellen is seen as more dovish than Summers would be.

(Read more: Twitter is going crazy with Larry Summers Fed buzz)

"I think without Bernanke there, without (Fed Vice Chair Janet) Yellen giving a speech, (Jackson Hole) is not going to be the kind of event we're used to having in the past," Kasman said.

Whither Stocks

Many analysts had expected smooth sailing for the stock market ahead of Labor Day, with a sideways move at best, and then a bigger chance of volatility in September when more traders are back at their desks. The Sept. 6 employment report is expected to be the first major event post-Labor Day, as it is viewed a major input for the Fed's decision-making process.

But the sudden move in yields has become unsettling for stocks, and Crescenzi said it could continue into the coming week. "There's potential for it because technicals are becoming a dominant influence in the bond market," he said.

Stocks, therefore, could remain volatile.

"I think the market's going to find reasons to be upset and finding reasons to worry. What's the Fed going to do? What these (meeting) notes mean. What they don't mean," said Freeman. "We'll get debate there. I do think that we've got some chances to get some pretty good swings in this market in the next couple of months, more than we've seen in a while. I think it will be an opportunity to accumulate cyclical stocks."

Freeman pointed out that while the S&P 500 lost 2.1 percent this past week to 1655, the biggest declines in major sectors were in defensive stocks, like utilities, down more than 4 percent, and consumer staples, down more than three percent. Consumer discretionary were also down more than three percent, after cautious forecasts from Wal-Mart and Nordstrom. But the best performers were cyclical, with tech and materials, both up 0.6 percent for the week.

"Could a 10-percent pullback occur? I think it could. If the announcement in September is that we're starting to taper, we might," he said. Freeman said he expects stocks to end the year between 1650 and 1700, but that p/e expansion could push the market above 1800 next year. "Everyone expected some kind of correction all the way up to (S&P) 1706. Now we've had a big move, and we have some differences and changes in policy, and I think it's just a transition."


Earnings: International Rectifier, Urban Outfitters, Bob Evans


Earnings: Home Depot, BHP Billiton, Medtronic, Best Buy, Dick's Sporting Goods, TJX Cos., Barnes and Noble, JCPenney, Saks


Earnings: Hewlett-Packard, Target, Lowe's, Staples, American Eagle, JM Smucker, Madison Square Garden, Toll Brothers, L Brands, Hain Celestial

7:00 am: Mortgage applications

10:00 am: Existing-home sales

10:30 am: Oil inventories data

2:00 pm: FOMC minutes


Fed conference at Jackson Hole, Wyo. Begins

Earnings: Dollar Tree, Hormel Foods, Sears Holdings, Gap, Pandora, Autodesk, Abercrombie and Fitch, Ross Stores, The Buckle, Marvell, Gamestop, Gold Fields, Aeropostale, Aruba Networks

8:30 am: Initial jobless claims

8:58 am: Manufacturing PMI

9:00 am: FHFA HPI

10:00 am: Leading indicators

10:30 am: Natural gas inventories data

11:00 am: Kansas City Fed survey

2:00 pm: Dallas Fed President Richard Fisher


Fed conference at Jackson Hole

Earnings: Ann, Foot Locker

10:00 am: New-home sales

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