Why we're in 'Tom and Jerry' market

Janet Yellen's latest speech put caution above the future upward path of interest rates. Coupled with the most recent FOMC 'dot plot' release, they are timely reminders of just what a cat and mouse game central bankers and investors indulge in.

Until very recently, the game seemed to have been put on hold as investors and the Federal Reserve fundamentally disagreed on the future path of interest rates. The mouse (the market) has been taking little notice of the cat (the Fed). However after the recent surprise announcement from the Federal Open Market Committee (FOMC), that may be about to change.

The most transparent communication tool the FOMC has – the "dot plot" of anonymous interest rate projections by the individual committee members – showed a big downward revision to median projections for this year and further ahead.

Federal Reserve Chair Janet Yellen
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Federal Reserve Chair Janet Yellen

But given that market pricing and the dots started so far apart, it's worth considering why the game of cat and mouse broke down. In order to do so we need to remind ourselves of how investors form expectations in general, and for central bank rates in particular.

Crudely, investors must base expectations on relationships between various prices and underlying data. Few if any of these relationships are easy to pin down, so markets incorporate uncertainty and take guidance from relevant institutions. For central banks, this translates into being transparent about their reaction function. We also get guidance from institutions on the underlying data, for example guidance on earnings from companies or macroeconomic forecasts from central banks.

However, markets frequently price in different outcomes from the guidance they are given. They may have a different take on the underlying data or believe the relationship behaves differently, or both. But the more investors disagree with the guidance the less attention they pay to it, so the guidance loses the ability to affect market prices.

That appears to be the situation the Fed has been in – investors completely ignoring the guidance from the dots in forming expectations for future rates. The mouse was not bothered about the cat.

Despite what the Fed was saying, investors refused to price in more hikes as financial conditions tightened in the U.S. and abroad. Market prices consequently settled well below the dots, in search of some kind of equilibrium between the FOMC's desire to tighten and financial conditions' rapid reaction. However, there was a high degree of uncertainty in these markets, as they had little useful guidance from the Fed to use as a reference point. The dots were just too far from the market to be informative. Disbelief ensued.

So where does the latest decision fit in? Well, the Fed needed to jolt things back into kilter. It appears to have done just that.

The dot path was lowered considerably, and the median dot now suggests two rate hikes in 2016. This change in guidance gives investors a reference point, which could allow expectations to latch on to the Fed's projections. As a result, market pricing could even end up higher despite the large shift in thinking from the FOMC. The cat is back to trying to push the mouse around.

However, while the latest guidance is a far better anchor, it is also giving the market a new upper bound for interest rates. After all, the Fed has shown a tendency to be too optimistic in its forecasts over the past few years. And the lack of scope to reverse course creates an asymmetry in policy setting for the Fed, meaning they will be keen to avoid tightening more than they have suggested.

Conversely, given that less tightening than suggested is not such an issue, as it would not be a major shock to markets or difficult to reverse, it is still quite possible that we get one or no hikes in 2016. Current market pricing reflects this, with the Fed Funds rate path still materially below the dots.

Armed with knowledge of this new 'upper bound', the big question that we are asking ourselves is: has the risk of fewer than two hikes increased? As far as we can see, not by that much.

So now that the Fed has revised down their rate hike projections to something realistic, there's a very real possibility that investors actually believe them. The result: a convergence of opinions as to the number of rate hikes this year, with two being the magic number. Cat and mouse is back on.

Commentary by Thomas Laskey, investment manager of fixed income EMEA at Aberdeen Asset Management.

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