Why the Fed could still surprise markets

The Fed could jolt markets Wednesday regardless of what it does, simply because of the wide divergence in Wall Street views about its move toward more normal interest rate policy.

The Fed this fall enters a period of policy transition, with the final wind down of its bond buying program to be announced in October-and then a slow walk to its first rate hike sometime next year. It is a turning point, around which the Fed will be forced to manage expectations while trying to keep the markets and economy on an even keel.

The divide in opinion is over whether the Fed will alter the language in its post meeting statement to recognize that it is getting closer to the time when it will begin raising interest rates from zero.

The Fed also releases its economic forecasts and Fed officials' views on the course of interest rates at 2 p.m. EST. Fed Chair Janet Yellen holds a press briefing at 2:30 p.m. EST, also a potential market moving event.

For days, markets have been moving closer to a view that the Fed will drop a dovish phrase from its statement, which says it would keep rates low for a "considerable time."

In a CNBC survey , more than 40 percent of the 37 respondents see the Fed dropping the reference to "considerable time." The market also has been speculating, but to a much lesser extent about the Fed altering language that says "there remains significant underutilization of labor resources."

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"The risk going in is that the Fed materially changes the language. Most people think they won't, and the market is more short than it was a week ago," said Ian Lyngen, senior Treasury strategist at CRT Capital. "That doesn't mean the baseline expectation was for a change. If you had to choose one risk it would be that the statement is a bit more hawkish. But the vast majority of people believe there will be no material change to the 'considerable time.'"

Stocks have been choppy as the markets mulled the potential for changes over the past two weeks, and rates edged higher. Stocks had their worst weekly performance last week since Aug. 1 and the first weekly loss in six weeks. But on Tuesday, stocks rallied and the Dow (Dow Jones Global Indexes: .DJI) rose 100 points after a Wall Street Journal article added fuel to speculation that the Fed would do nothing. Lyngen said there was short-covering in Treasurys.

Stocks tend to gain on average on Fed meeting days. According to Bespoke, since the Fed moved to zero interest rate policy in 2008, the S&P 500 (^GSPC) has averaged a half percent gain, versus a 0.35 percent Fed day gain since 1995. On the last six meeting days, since the Fed began tapering quantitative easing, stocks were higher on four of them, including the last three.

"If nothing is changed, I think that is a bullish event for the Treasury market. In bonds, 10s (10-year notes) and 30s would lag in a rally if nothing is changed, I think that is a bullish event for the Treasury market. If they do change it, I think you could see the curve bear flatten, led by 3s and 5s and to a lesser extent and to a lesser extent 2s." In essence, short-term rates would rise on expectations of a higher Fed funds rate.

Strategists said if the Fed does nothing, the dollar could weaken and stocks could rally a bit more.

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"Those are relatively small moves in comparison to the potential for the statement language changing," said BlackRock's Jeffrey Rosenberg of the recent speculative market moves. "It certainly tells you about the amount of short-term positioning in the market either way ... looking at these market moves is disconcerting but you lose sight of the broader and bigger picture of whether its tomorrow, or October or December, we're going to face a period of policy normalization. This is going to be a big deal and full of meaning" after six years of super low rates.

Wall Street's economists are divided about whether the language will be changed. Goldman Sachs (GS) expects the "considerable time" phrase to remain, while Bank of America (BAC) and JPMorgan expect the "considerable time" phrase to be dropped.

"The characterization of the labor market is at odds with incoming data, and that really is the debate. If the Fed is truly data dependent, then the language has to change," said Rosenberg, BlackRock's chief investment strategist for fixed income. "There is a conflict between the characterization, the language and the data, and that's what's getting the markets into a frenzy in terms of the speculation."

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Jack Ablin, CIO of BMO Private Bank, said he doesn't expect a change in the Fed statement yet, but he said if there is then interest rate sensitive and commodities-related stocks could get hit, as they are vulnerable to a higher dollar.

"I think there's just much ado about nothing," he said. But Ablin did take a look at how different asset classes performed when the yield on the 10-year yield moves higher by 10 basis points or more in the course of a week. The S&P 500 performed the best on average in the nine such occurrences over the past 50 weeks.

"The average return of the S&P was a half percent for the week because rates were rising on better economic news. It's a positive. What got hammered? REITs and gold," he said.

Lindsey Group chief market analyst Peter Boockvar said the focus should be more on the language about labor slack because if the Fed changes that line in the statement, it would be a real indication that it sees less labor slack and rates will rise sooner.

Rosenberg said markets will focus on the language, and then move onto the Fed's forecast and the chart of interest rate expectations of Fed officials, which will now include 2017.

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Goldman Sachs economists expect to see the chart, which uses dots to represent anonymous Fed official forecasts, to show a small increase in the median forecasts for the Fed funds rate to 1.25 percent in 2015, an unchanged 2.5 percent in 2016 and a new rate of 3.5 percent in 2017.

Besides the Fed, there are mortgage applications at 7 a.m. EST, then CPI inflation data and the current account, at 8:30 a.m. EST. The National Association of Home Builders survey is at 10 a.m. Government oil inventories data is at 10:30 a.m. and will be important after West Texas Intermediate crude rallied more than 2 percent Tuesday on comments from OPEC that it expects lower production.

Earnings are expected from FedEx (FDX), General Mills (GIS), Cracker Barrel (CBRL) and Lennar, ahead of the opening bell. Herman Miller and United Natural Foods report after the close.

-By CNBC's Patti Domm