By Ryan Vlastelica
NEW YORK (Reuters) - Months of anticipation will come to an end next week when the Federal Reserve finally says whether it will start to rein in its massive stimulus of the economy, which has flooded financial markets with some $2.75 trillion over the past five years, supercharging returns on everything from stocks to junk bonds.
But for all the concerns that the reduced presence of such a giant asset buyer would be calamitous for investors, it appears equity and bond markets are poised to take next week's Fed decision largely in stride - provided the central bank doesn't surprise with the size of its move or shock in some other way.
The Fed has telegraphed its intentions to pare back its monthly purchases of $85 billion in bonds at its two-day meeting that ends next Wednesday. The scale of the tapering and what Fed Chairman Ben Bernanke might say at his press conference are key here, but the steady messaging in the last few months means next week probably won't see carnage in the markets.
Investors have already done a lot of work in absorbing the Fed's message. Benchmark bond yields are now hovering near two-year highs, while stocks have edged off highs reached in early August, removing some of the froth that had started to concern some investment strategists.
"The Fed already got tapering without actually tapering," said Daniel Heckman, senior fixed income strategist at U.S. Bank Wealth Management in Kansas City, Missouri.
Key measures of volatility and futures positioning show there is not much fear. The CBOE Volatility Index (^VIX), the market's favored gauge of Wall Street's anxiety, hovered around 14 on Friday, a level associated with calm markets.
The Fed has said it would wind down its program if it is confident that the economy is improving, particularly that the jobless rate is heading lower. If it delays any action, it could raise concerns that it fears economic growth is going to be too anemic without the Fed's help.
Recent data has been mixed, with August jobs and retail sales data falling short of expectations. Consumer sentiment has fallen in part due to rising interest rates.
That's prompted analysts to issue only modest forecasts for the reduced buying. A Reuters poll showed a consensus for the program's $85 billion monthly pace to be cut by $10 billion, less than earlier estimates.
However, the current low volatility means the Fed runs the risk of spooking markets if it moves too quickly or surprises with its intentions.
"The Fed needs to move from being aggressively stimulative to merely very stimulative," said Leo Grohowski, chief investment officer at BNY Mellon Wealth Management in New York. "Markets are less prepared for it to do more, and if it does you might see a return to defensive areas."
In May, after Bernanke spoke about potentially slowing stimulus this year, the S&P 500 (^GSPC) fell 7.5 percent. The index is unlikely to see a similar decline on any surprise next week, with many analysts citing its 50-day moving average as support. Currently, the index is 0.7 percent above that level.
Still, investors have been taking steps to reduce risks ahead of such an important announcement. Trading in options of the S&P 500 tracking exchange traded fund - the SPDRs (SPY.P) - was dominated by bearish put buying. Put contracts give a holder a right to sell a security by a given date at a certain price, and are generally used to hedge against declines.
A total of 1.16 million puts and 559,000 calls changed hands in the SPY fund on Thursday, a ratio of 2.08 to 1, according to options analytics firm Trade Alert. That ratio is above the 22-day moving average of 1.64.
"As we head into the weekend and the Fed meeting next week, traders are starting to hedge their long equity positions," said JJ Kinahan, chief strategist at TD Ameritrade.
Michael Mullaney, who oversees $10.7 billion as chief investment officer at Fiduciary Trust Co in Boston, said his firm was pulling back because of the uncertainty.
"We don't want to get aggressive for a while; there are just too many uncertainties to get through before we add more risk," he said, also citing seasonal issues and government budget policy as overhangs.
That sentiment prevailed among many investors in August, resulting in a 3.1 percent loss for the S&P that month, the worst monthly performance in a year. That decline helped restrain S&P valuations, with the forward price-to-earnings ratio of the S&P 500 currently at 14.6, according to Thomson Reuters data, in line with a historic average of 15.
Sectors tied to the pace of economic growth have been among the biggest beneficiaries to the Fed's policy, with both the financial (.SPSY) and consumer discretionary (.SPLRCD) groups up more than 20 percent this year, outpacing the S&P 500's (^GSPC) 18-percent rise. Any surprise from the Fed could hit those groups the hardest.
"Those economically sensitive groups would pullback the most, and housing is at the top of any list of vulnerable sectors," said BNY's Grohowski, who oversees about $175 billion in client assets.
Housing stocks (.HGX) have performed well recently, rising 6.3 percent in September, but remain more than 16 percent below a peak reached in May. The sector could weaken further if the Fed takes any steps that lead to a rise in interest rates.
"Both stocks and bonds will like it if the Fed tapers $10 billion only in Treasuries. If it pares down on its mortgage-backed security purchases, we're very worried about what that will do to the housing market," said Mullaney.
The Fed is expected to maintain its current level of purchases of mortgage securities, focusing instead on pulling back on its $45 billion in monthly buys of Treasury notes. Anticipation of this has pushed yields on the 10-year Treasury note higher for five straight months.
Still, blistering demand for Verizon's (VZ.N) record $49 billion bond deal this week, together with a solid reception for the government's $65 billion in debt supply this week, signaled investors might have grown less wary of reduced stimulus.
HURTING EMERGING MARKETS
In the currency market, an aggressive Fed could lift the U.S. dollar "by pushing rates up at the long end, making U.S. yields more attractive, and at the short end as well, making Japanese investors, among others, worry that hedging costs could go up quicker than expected," said Steven Englander, head of currency strategy at CitiFX, a division of Citigroup, in New York.
Emerging markets were hardest-hit once the Fed started to lean in the direction of cutting stimulus, with sharp selloffs in debt and equity markets around the world. Some markets have since recovered some losses, but investors have been hedging against any Fed shock that could hit those markets.
Mike Tosaw, financial advisor at RCM Financial Services, an investor advisor in Chicago, said his firm has a put position on the iShares China Large-Cap ETF (FXI).
"Now is definitely not the time to take it off because what happens with the FOMC meeting next week could have a ripple effect on global markets," Tosaw said.
While the Fed will be the primary market driver next week, investors will also look to quarterly results from FedEx Corp (FDX), viewed as a proxy for economic activity, and software giant Oracle Corp (ORCL). The market will also see data on August housing starts and existing home sales, and the monthly Philadelphia Fed business index.
(Additional reporting by Doris Frankel in Chicago, Richard Leong and Julie Haviv in New York; Editing by David Gaffen and Tim Dobbyn)