LONDON (Reuters) - Financial markets were growing nervous on Tuesday ahead of a two-day U.S. Federal Reserve meeting that investors hope will finally clear up when it plans to start winding down its huge stimulus program.
The debate over when the Fed will begin to halt the flow of cheap dollars has dominated trading worldwide for months amid worries it could trigger a turbulent reaction from investors who have become all too used to the support.
A majority of economists polled by Reuters still expect the Fed to wait until March before it starts to scale back its $85-billion-a-month program, but recent data have steadily shortened the odds on a move in January - or even this week.
The dollar .DXY and benchmark government bond yields were in suspended animation as the countdown to Wednesday’s Fed decision began, and the so-called VIX ‘fear gauge’ .VIX hovered at its highest level in two months.
Philip Marey, a U.S.-focused economist at Rabobank, said he expected the Fed to wait until the new year to move.
But with the economy picking up and Washington having reached a preliminary budget deal last week, he added that it was likely to be a close call, with inflation probably the only major sticking point.
“The labor market data has been strong over the last couple of months so in that respect the evidence is there to start tapering... But the PCE indicator, which is their main measure of inflation, has fallen to 0.7 which is very low.”
With fresh inflation data due at 1330 GMT U.S. futures pointed to a soft start on Wall Street, while in Europe shares were already suffering another difficult day.
Many investment banks have tipped them to be star performers next year. But falls of 0.5, 0.4 and 1 percent on London’s FTSE .FTSE, Paris’s CAC 40 .FCHI and Frankfurt’s Dax .GDAXI took back much of Monday’s gains and left them down almost 4.5 percent this month.
Traders were also opting for caution in currency and bond markets. While a move to start trimming stimulus would be a symbolic signal from the Fed, its cautious approach has managed to convince markets that rate rises remain distant.
Ten-year U.S. Treasury yields, the benchmark for global borrowing costs, were slightly lower at 2.8628 percent after a largely quiet morning in Europe for both them and euro zone government bonds. <GVD/EUR>
Analysts at Societe Generale predicted a January start to tapering but said “the economic case has already been made for pulling the trigger.”
The only reason to delay would be to give the FOMC the opportunity to strongly signal its intent, they said. “In either case - actual taper or signal of impending taper - we expect the 10-year U.S. Treasury yield to test 2.9 percent.”
Many analysts have been expecting the dollar to rise as the prospect of tapering strengthens. It has made some ground against the yen, but the euro’s recent rise has all but cancelled out the gains.
One reason has been tighter euro money markets as banks have repaid cheap ECB loans faster than expected. That has cut the central bank’s balance sheet by 8 percent this year, although Frankfurt has shown no real alarm at the move.
The euro was barely changed at $1.3760 at 1300 GMT, giving up gains it made after Germany’s ZEW business sentiment came in well above expectations and euro zone inflation came in stable.
It meant it also stayed within reach of a five-year peak against the yen at 141.75 yen, and rose against the Swedish crown after the Riksbank cut its repo rate, as expected.
Further gyrations may come later with the release of U.S. inflation data. As Rabobank’s Marey stressed, subdued U.S. prices have been one of the only things holding the Fed back from tapering, so any sign of firming could clinch a move.
“(Euro/dollar) above $1.35 is not fundamentally justified if you look at what’s happening in the U.S. and Europe. But underlying flows are euro-positive,” added Carl Hammer, chief currency strategist at SEB in Stockholm.
In emerging markets, the wait for the Fed meant the Indian rupee, Indonesian rupiah and Philippine peso underperformed their Asian peers. <EMRG/FRX>
Focus also remained on the upheaval in Ukraine as President Viktor Yanukovich headed to the Kremlin seeking a financial lifeline, as demonstrators in Kiev gathered once again to demand he steps down.
In the southern hemisphere, the Australian dollar was little changed near a 3-1/2 month low after the Reserve Bank of Australia said there were signs its past cuts in interest rates were working, though it wouldn’t rule out further moves.
“Money-market pricing on the next full 25 basis points move remains for a hike in 2015, suggesting that there may be some further scope for AUD-negative adjustment,” Todd Elmer, head of G10 strategy for Asia ex-Japan at Citigroup in Singapore.
Among commodities, U.S. crude prices eased 0.2 percent to about $97.3 a barrel. Brent dropped to $108.63. Gold dipped to around $1,246 an ounce as it struggled to keep a grip on a third day of gains. <GOL/>
Additional reporting by Thuy Ong in Syndney; Editing by Eric Meijer and Larry King