How markets may react to the Fed's next move

NEW YORK Wed Dec 18, 2013 2:11am EST

Traders work on the floor of the New York Stock Exchange shortly after the market opening December 16, 2013. REUTERS/Lucas Jackson

Traders work on the floor of the New York Stock Exchange shortly after the market opening December 16, 2013.

Credit: Reuters/Lucas Jackson

NEW YORK (Reuters) - Reactions in financial markets to any step the Federal Reserve may take on Wednesday to start reducing its massive stimulus program will likely be less dramatic than market convulsions seen when the prospect of a so-called taper emerged earlier this year.

Evidence of faster job growth and a pending two-year budget deal in Washington make it easier for the central bank to make a policy pivot and easier for investors to cope with it, analysts and investors said ahead of the Fed's policy statement, due on Wednesday at 2 p.m. (1900 GMT). <FED/DIARY>

The Fed surprised markets three months back by opting not to reduce its third round of quantitative easing, under which is it buying $85 billion a month in longer-term Treasuries and mortgage-backed securities.

Earlier, benchmark 10-year Treasury yields had risen to a two-year high and stock prices retreated by more than 5 percent after Fed Chairman Ben Bernanke said the U.S. central might soon reduce its purchases. Markets appear better positioned since that earlier false start, analysts said.

"At the end of the day if the market is given the option to rally on better data or on more liquidity, it would rather see the economy strengthening," said Andres Garcia-Amaya, global market strategist at JPMorgan Funds in New York.

Treasury yields have already risen from rock-bottom lows and cash has found its way out of emerging markets, which are seen as among the most vulnerable to a taper.

"If tapering does occur, I would expect probably a little bit of weakness in ... Brazil, India, Indonesia, South Africa and Turkey," said Jorge Mariscal, chief investment officer for emerging markets at UBS Wealth Management in New York.

"There are some other countries that do have a significant exposure through the local bond markets, including Mexico, South Korea and Poland. I could see temporary weakness in their exchange rates as a result of capital flight."

U.S. stocks, which are just over 1 percent off their all-time high, could face some choppiness, but there appears to be little expectation for an all-out correction in equity prices.

Wall Street reckons the Fed faces a handful of basic options for Wednesday's policy statement. Here's three:

* Reduce stimulus;

* Continue the program but signal the intention to shrink bond purchases in the new year;

* Leave everything pretty much the same.

Below are what analysts consider may happen on Wednesday in the U.S. bond and equity markets in reaction to those three scenarios:

SCENARIO 1: The Fed moves to taper

Bonds: Look for bond yields to rise depending on the size of the purchase reduction.

If the reduction is small, on the order of $10 billion or less, l0-year and 30-year Treasuries yields will likely rise toward 3 percent and 4 percent, respectively, from their current respective levels of 2.84 percent and 3.87 percent.

If it is large, in the $20 billion to $30 billion range, a heavy sell-off could materialize among three-year and five-year issues on fears of an earlier-than-expected increase in interest rates. "It will shrink the timing of a rate hike if they taper aggressively," said David Keeble, global head of interest rates strategy at Credit Agricole & Investment Bank in New York.

Stocks: The knee-jerk reaction would be a selloff. But it would be hard to find a money manager who wants to be entirely out of stocks, and a pullback could quickly become a buying opportunity.

The reaction will reflect "how much time people have had to realize this is coming and how much selling has occurred in anticipation of this in the last week," said Rick Meckler, president of investment firm LibertyView Capital Management in Jersey City, New Jersey.

"The market will trade down a lot on the announcement but then recover during the day to be down but not more than 1 percent" at the close, he said.

SCENARIO 2: The Fed doesn't taper but changes language so that it's clear that it will taper in early 2014.

Bonds: Bond yields may fall modestly, led by shorter-to-medium Treasuries as such a decision would support the view of a gradual tapering.

Stocks: "Early next year" is really just around the corner and the reaction from traders will probably be similar to an outright taper -- a short-term selloff.

"Markets have been surfing this tsunami of liquidity," said Chad Morganlander, portfolio manager at Stifel, Nicolaus & Co in Florham Park, New Jersey. "Any reduction in the Fed's asset-purchase program will take speed off the fast ball, which should not be a surprise to anyone."

Under this scenario the next batch of economic data become crucial, as it will have to confirm the recent bets on a stronger economy in 2014.

SCENARIO 3: The Fed doesn't taper and keeps language more or less unchanged.

Bonds: Bond yields might fall sharply at first but retrace much of the decline quickly since the Fed would keep investors guessing about the timing of tapering and a first rate hike.

"We will get a bounce, but it might be short-lived," said Arthur Bass, co-head of financial futures and options at Newedge in New York.

Stocks: The Fed's September surprise was a boon to equities, which had priced in a stimulus reduction. But this time around -- even if recent polls still point to March as the beginning of the end for quantitative easing -- anything different from a specific timeline could backfire.

"There would be no reason for a long-term rally on the idea the Fed's not sure if the economy is strong enough," said JPMorgan Funds' Garcia-Amaya.

(Reporting by Richard Leong and Rodrigo Campos; additional reporting by Vidya Ranganathan and Walter Brandimarte; Editing by Leslie Adler)