Does rubbing out varnish ever cloud the grain and reduce the visibility?
Yes, a matt varnish is inherently less clear than one that is glossy. It's just like the difference between frosted glass and regular glass in essence, only not so pronounced.
The slight reduction in clarity is not usually a problem.
My current plan is to just buff out the varnish with sandpaper in increasing grits. Will this technique work?
No need to do that, you can do it in a single operation by just rubbing down with fine steel wool; you can do it dry or lubricated with wax if you prefer. This is the classic method to reduce the sheen on a film finish (shellac, varnish and lacquer).
Do ensure the varnish has had a chance to cure and get hard beforehand. This will take from a couple of days to a week or longer.