Reality of the virtual: Authority, language & Fed
There is a general perception that there is no urgency for the Fed to hike and that, in the environment with one-sided positioning and highly regulated markets and compromised liquidity, rate hikes could be highly disruptive for the markets. Yet, Fed is unlikely to give up its option to raise rates. Why? The problem is not only economic, but also linguistic. For years now, it can be argued, the Fed’s role has extended from inflation and growth to stability of the markets and shifted towards maintaining symbolic order. Since the moment when unwind of the stimulus became the main theme, Fed has been acting increasingly as a symbolic authority. But, for an authority to function as an effective authority, it has to remain not-fully-actualized (rate hikes, which are seen as a persistent “threat”, must remain virtual). This is the reality of the virtual — the real effects produced by something which does not fully exist. In this way the Virtual acts as the stable focal point around which all elements circulate.
In the last years, the dialogue between the Fed and the markets has given rise to a particular code of communication that has developed all characteristics of a real language with all of its symbolic dimensions. And, here is where things become non-linear. Speech never merely transmits a message; it always also asserts the basic symbolic pact between the communicating subjects. In that sense, language is a “gift”, but a dangerous one: it offers itself to our use “free of charge”, but once we accept it, it colonizes the landscape.
The most elementary level of symbolic exchange is a so called “empty gesture”, an offer made or meant to be rejected. Accepting such an offer causes disintegration of the symbolic order and the dissolution of the social link. In this constellation of things, rate hikes is a threat, omission of an individual hike is a concession. As such, a threat of continued hikes remains virtual – a hiking cycle remains virtual, but the Fed can never fully relent. However, individual concessions should be in play as well as an implicit understanding that the link between market stability and accommodative Fed is the underlying pattern.
Even though the market could continue to insist on Fed dovishness, the Fed will refuse to relent explicitly precisely because relent would be an empty gesture that the market would not refuse, and this acceptance would disturb the existing symbolic order. And, if the market continues to trade “dovish” with aggressively discounting the possibility of rate hikes in the near term, this could actually increase the likelihood of Fed hikes in an effort to recenter the dialogue and maintain its authority.
In all likelihood, this will keep the premium at the front end of the curve, while bullish pressures in the belly could continue as terminal rates are priced lower and corresponding risk premium ironed out. All else being equal, this configuration should remain constructive for the belly of the curve. At current levels of vol and steep forwards, 1X2 receiver spreads imply breakevens comfortably outside historical extremes. We are buyers of curve cap calendars and contingent steepeners, as well as equity rate hybrids.