By Rodrigo Campos
NEW YORK (Reuters) - For the past few months, the Federal Reserve has been squarely in the financial markets' corner, thanks to its massive dollops of monetary stimulus. But signs that the central bank is discussing reducing that support by purchasing fewer bonds mean that trading is likely to get bumpier in coming months.
The Fed's evolving stance was made apparent by Federal Reserve chairman Ben Bernanke's remarks to Congress Wednesday, where he laid out the conditions that might cause the Fed to reduce its $85 billion a month buying of Treasuries and mortgage-backed bonds.
U.S. stock and bond markets were whipsawed - the S&P 500 rose dramatically On Wednesday, only to fall sharply in its largest one-day point swing since early November, and bond yields rose above 2 percent to a 10-week high. On Thursday, both markets stabilized.
Volatility has been low over the past few months. The 50-day moving average of the CBOE volatility index, Wall Street's favorite fear gauge, hit a six-year low last week. In the past two days it rose as much as 13 percent, but it remains at historically low levels. That may change, depending on future remarks and moves by the Fed.
"As you start hearing about the Fed tapering off asset purchases I wouldn't be surprised if that spooks investors and you begin to see volatility pick up," said Joseph Tanious, global market strategist at JPMorgan Funds.
Fed officials say they will need more signs of sustained improvement in the economy and the labor market before reducing the bond buying that has lowered borrowing costs, underpinned a rebound in housing, and helped to boost stocks to record levels.
Since its November lows, the S&P 500 has gained nearly 25 percent. In that time, corrections have been brief - with the largest drop a 3.8 percent fall over a five-day period in April. Wednesday's action looked like the initial stage of a larger pullback.
"This wobble is coming from sellers who view much of the stock market's ascent as being mostly attributable to central bank liquidity provisions, and less so to any fundamental economic improvement," said David Joy, chief market strategist at Ameriprise Financial in Boston.
With a stronger economy as a prerequisite for a Fed exit, for now analysts see U.S. stock market declines related to fears of Fed decisions as buying opportunities.
Thursday's action speaks to that point. In the early going, the market looked primed for its second consecutive drop of more than 0.8 percent, which would have been the first such occurrence since November. But buyers jumped in, and the S&P ended just 0.3 percent lower.
The Fed will however have to walk a thin line as it communicates its next policy steps. Officials including New York Fed President William Dudley have cautioned against investor over-reaction to policy adjustments.
"The Fed won't adjust unless and until it is convinced that the private sector can function well, and sustainably so, without the present extent of accommodation," Joy said. "That should be viewed as a welcome economic vote of confidence."
PULLBACK IN THE CARDS
With the sharp rally, stocks were nearing overbought levels in various technical readings and Bernanke's Congressional testimony on Wednesday, taken as slightly hawkish, was seen as an opportunity for investors to take some profits off the table.
Adding to investors' jitters, minutes from the latest Federal Open Market Committee meeting show a hawkish bent in the policy-setting group, with some members discussing if it would be appropriate for the unwinding of stimulus to begin as early as June.
When the Fed eventually reduces its monthly bond buying, known as quantitative easing, that should be reflected in the Treasury market. Goldman Sachs strategists said this week that the fair value of the 10-year yield is closer to 2.5 percent. That may also have an effect on corporate debt, where the yield on the average high-yield bond recently dipped below 5 percent.
"A cessation of QE would certainly precipitate a re-pricing in the market," said Bonnie Baha, head of Global Developed Credit at DoubleLine Capital LP, which manages more than $60 billion in Los Angeles.
"I doubt, however, that Bernanke envisions ending QE cold-turkey. His remarks yesterday were most likely a trial balloon. He has not taken ongoing bond-buying off the table," she said.
The rise in yields should be gradual. In its note, Goldman Sachs said rising yields may not even hurt equities, because it would suggest less uncertainty about the outlook for growth or inflation. That said, previous instances where it appeared the Fed was going to reduce support for markets have jolted the stock market.
"I think the market is overreacting, and overly focused on this notion of tapering," said Steven Einhorn, vice chairman at hedge fund Omega Advisors Inc in New York.
"I don't think it's at all imminent. I think Bernanke and his associates have made clear that before they opt to taper they want to see substantial improvement in the labor market."
(Additional reporting by Herbert Lash, Chuck Mikolajczak, Jennifer Ablan, Steven C. Johnson and Wanfeng Zhou; Editing by Martin Howell, David Gaffen and Leslie Gevirtz)