by John Coates
Through its influence on the locus ceruleus, information thus registers as a lot more than mere data: it registers as a bodily reaction. Information becomes physical. So tight is this relationship that Daniel Berlyne, a psychologist working at the University of Toronto in the 1960s, graphically plotted arousal against information and found an elegant shape. What Berlyne’s hill tells us is that low levels of information, such as we encounter in a dull conversation, leave us bored and sleepy, while high levels of complexity, such as we might find in a movie with a difficult-to-follow plot or in an overload of files at work, confuse us and promote a state of anxiety. But just the right amount of information piques our curiosity, quenches our thirst for novelty, and provides a diffuse feeling of satisfaction that spreads throughout body and brain.
To avoid swamping us in complexity and creating constant anxiety, the brain must distinguish significant information from the trivial. The locus ceruleus cannot do this on its own. To sift the meaningful from the meaningless, we rely on visceral judgements not unlike gut feelings. Several higher-brain regions, in the hippocampus and posterior parts of the neo-cortex, yet still operating below the level of conscious awareness, scroll rapidly through patterns stored in our memory banks and compare them with the facts now before us. The process of pattern-matching is given an urgency and a motivational edge by the amygdala, which tags each pattern with an emotional feeling, giving you a quick and dirty assessment of the potential threat or opportunity facing you. This tag team of pattern recognition, emotional assessment and alarm centre sifts information and provides us with the gut feelings we need to prevent us from being fooled by unimportant information.
We feel these fluctuating assessments of importance throughout the day. Some event catches our eye, and we hover between attending to it or turning away. Noticing a chair unexpectedly hanging from the ceiling of an art gallery may provoke a moment of curiosity, but unless the installation has some deeper significance we quickly habituate to the scene and lose interest. In fact, without the guiding hand of our gut feelings, the locus ceruleus would be forever lost in wonderland, distracted, like a child, by ever new sights. A lot of fantasy literature relies on just this sort of initial amazement. But what separates the throwaway books of this genre from classics such as Ursula LeGuin’s Earthsea novels is a parable that taps into our deepest concerns. The visual arts today also rely on what the critic Robert Hughes calls the Shock of the New, but here as well our gut feelings distinguish (even if the market does not) between the deep and the shallow. The locus ceruleus may be tricked by shocking art, just as it is by eye-catching advertising; but only if the amygdala and higher-brain regions, and indeed our entire body, are engaged does a surprising piece of art, like the best conceptual installations, find roots in our deepest uncertainties and promote a satisfying and lingering arousal. Good art critics rely on gut feelings just as much as profitable traders.
The need to distinguish trivial from important information is nowhere more pressing than in the financial markets. Every newsworthy event across the globe, be it the Bank of Japan raising interest rates, the announcement of Chinese industrial production, Eurozone inflation, a hurricane approaching the Gulf of Mexico, shows up on scrolling news feeds and in market prices. The information pours in non-stop, like a never-ending and uncompressible message, a telegraph that never stops clicking. Every change in the world shows up as price changes in the bond, stock, currency or commodity markets. The more information pouring in, the greater the uncertainty, the higher the market volatility. Financial market volatility thus provides the most sensitive barometer of what one might call global arousal, the amount of novelty in the world. In fact there is a futures contract traded on the Chicago Board Options Exchange called the VIX which tracks this very uncertainty, being an index of the financial community’s expectation of how much the market will move in the coming months. It has for good reason been called ‘the Fear Index’, and when the credit crisis of 2007–08 erupted the VIX spiked from a sleepy 12 per cent to over 80 per cent in a matter of months.
A human brain trying to map all the information in the financial markets would soon collapse with exhaustion. Few professions, with the exception perhaps of air-traffic control or the military during time of war, compare with finance for the amount of information that must be sifted and processed in real time. But skilled traders and investors can do it. They can separate the signal from the noise, and feel in their bodies when the chaos on the screens can be safely ignored and when it cries a warning that should be heeded. Good traders like Martin do not just process information, they feel it. There are few phenomena in finance more remarkable, even mysterious, than this close linkage between market and body.
The picture conjured up by this research on information and arousal is of a constant call and echo between market and trader. The market broadcasts its information, beats out its message on the tom tom of volatility, and the very body of a trader, like a tuning fork, vibrates in sympathy. I am not sure traders are ever fully aware of this fact, since much of it takes place pre-consciously. Judging from my own experiences, my observations of other traders, and my experiments on a trading floor, I would say they usually are not. Yet market information and trader arousal wax and wane together, dragging the trading floor, whether it is aware of it or not, willing or not, across Berlyne’s n-shaped hill, from boredom through excitement to anxiety and stress.
THE FED!
And that is why today, at around 11 a.m., the first inklings of the coming storm were felt in the bodies of traders and salespeople. The bodies of these unsuspecting bankers have already taken the first steps in gearing up their defences. Arousal flickers and their gaze orients to the disturbance. Logan, in mid-throw, looks over his shoulder at the screens. Scott has already wheeled his chair back to his desk. They sense something is wrong, but are not sure what. One by one, on desk after desk, and all along Wall Street, traders and salespeople dip their newspapers to look at the screens, phone conversations are politely cut short – ‘Look, can I call you back?’ – donuts remain half-eaten. Martin, Gwen, Logan and Scott, electrified by heightened senses, quickly register the slight changes taking place on the broker screens and begin the cognitive task of figuring out what is agitating the market.
Ash, the head of the trading floor, looks up from his papers and steps out of his office, surveying the floor. Then, strolling up to Martin, hands in pockets, he asks, ‘What’s up?’
Martin, twirling his pen and holding the screens in a steady gaze, replies, ‘Not sure. Feels like the market might break down.’
At that point a salesman on the mortgage desk yells to Martin, ‘Wells Fargo hearing the Fed may raise half a point this afternoon. You know anything about this?’
Martin and Ash look momentarily shaken. But Ash quickly dismisses the suggestion. The Fed does not leak rate moves in this way. If it wants to warn the markets, and it usually does, it hints at its intention of changing interest rates weeks in advance, not on the very day when the Board of Governors meets to finalise its decision. Most bankers know this, yet the market appears to be taking this rumour seriously. As the rumour mill of Wall Street goes to work refining the story, it emerges that one of the governors of the Fed gave a speech last night to a small group of senior bankers in which he spoke in no uncertain terms about how concerned the Fed is by what it considers an unjustified rally in stocks. He made it known that the Fed will not tolerate a bubble and the threat it poses to the stability of the financial system. One of the bankers in the audience took the speech as a pretty clear message that the Fed would raise rates today, and after giving his own bank time to set its positions for the rate hike he passed on his views to clients. Hence the news now seeping into the market.
An increase in interest rates by the Fed, especially on a day when no one expects it, would send a tidal wave of volatility through all financial markets, devastating prices. The interest rate set by the Fed acts as the benchmark against which all assets are va
lued, so when it changes the prices of all other assets have to change as well. Assume that the Fed has set its interest rate at 5 per cent. And further, assume that you hold your savings in a balanced portfolio of assets: you own stocks which pay a dividend of about 3 per cent and which in addition go up in price on average about 4 per cent a year; bonds which yield 5 per cent; and a small amount of commodities, such as gold, which yield nothing but go up in value during times of inflation. Now, what happens if the Fed raises its rate to 6 per cent? All of a sudden the assets you own no longer look so attractive. Your stocks now yield a full 3 per cent less than what you could earn in a savings account; your 5 per cent return on bonds looks paltry compared to the 6 per cent you could receive on new bonds; and the money you have invested in gold, forgoing the 5 per cent you could have received from bonds, could now be earning 6 per cent, making it that much more painful to hold this inert metal. Consequently, rate hikes by the Fed commonly depress the values of all assets. That is why experienced hands on Wall Street keep in mind a sage piece of market lore: never fight the Fed!
This market is not in a fighting mood, so it acts accordingly. Stocks sober up to the reality that their party may be coming to an end. The Fed could take away the punchbowl of easy money, and if it were to do so in earnest it would spell the end of the glorious bull market that has lifted stocks almost 40 per cent over the past two years; so in the next half hour the S&P index drops almost 2 per cent. Commodities too take a hit, with gold down $5 an ounce and oil $2 a barrel. However, it is in the bond market, the market for interest rates itself, that the news has its most immediate and undiluted effect. If the Fed were really to raise rates half a per cent, the bond market would be knocked to its knees.
Ash asks how the desk is positioned, and is relieved to hear that it has no large positions, nothing dangerous. He rushes off to talk to other trading desks. Martin calls his traders together for a hasty meeting. A dozen traders lean in to the pow wow. What happens to bonds, they speculate, if the Fed hikes rates a quarter point? Half a point? What happens to stocks? But their strategising is cut short. The squawk box begins to crackle with salespeople around the world calling in client trades – bid $150 million five years for Industrial Bank of Japan, $375 ten years for Monetary Authority of Singapore, $275 million long bonds for a French asset manager – and the Treasury market begins to fall. Martin has been caught unprepared for this avalanche of business and the yawning hole that has opened up in the Treasury market, taking the market down a quick half-point. Quickly adapting to the volatility and to the non-stop client trades, he disappears into his zone; this is what he has trained to do, and he does it well.
The initial trades he parries well, as does Gwen, buying bonds from clients and selling them into the screens, making small amounts of money on some but mostly breaking even, which in this terrified market is a relief. In the last fifteen minutes, however, the client selling has turned relentless, pushing the ten-years’ total loss to almost a full dollar. Even an old hand like Martin has trouble staying one step ahead of the market. The last block of bonds he bought from a client he has not managed to scratch, having to sell half of them at levels below where he bought them, and the other half he has not been able to sell at all. As the market continues to fall, these bonds start losing money at an alarming rate. Other traders along the desk find themselves in a similar predicament, and slowly retreat behind a barrage of selling. Gwen struggles with $450 million fives, most of which she bought from the Caisse de Depot, a government fund in Quebec. Martin has to concentrate on getting out of the desk’s existing risk rather than buying more bonds, so he lowers the bids he shows clients and starts missing business. Traders are always caught between the need to make money and the need to keep clients and sales force happy. In markets heading in one direction, and fast, as they are today, the two usually conflict. As the morning wears on, the Treasury desk leaves a trail of disgruntled salespeople, and the goodwill established by the DuPont trade quickly burns off.
Then, as these things generally go, the rumours, never terribly reliable in the first place, get hijacked by fear, and reason deserts the field. Rumour now has it that the Fed will hike rates three quarters of a point, and that this may be just the beginning of a concerted round of tightening to follow in the months ahead. The sell-off turns into a freefall, the ten-year dropping another half-point without much trading taking place, the five-year about the same. In fifteen minutes Martin has lost maybe $1.75 million on the bonds he has not been able to sell, Gwen another $2 million on her five-year position. The Treasury traders now feel besieged. Altogether they have lost well over $4 million on long positions they cannot get out of, a lot more than Martin made on the DuPont trade, and a murmurous concern spreads among neighbouring desks. What is more, black boxes, taking advantage of the fear and volatility and the traders’ loss limits, are pushing the market down, hoping to make traders panic.
For Martin, this sell-off has turned into a white-knuckle ride. But he is a hardened campaigner from much worse crises, and he does not lose his cool. Immersed in the flow and absorbed by the activity, he nonetheless mulls the information, scrutinising every price change, its size, speed, the volume of bonds traded; he listens to the client trades streaming onto the floor, through both his desk and distant ones – the mortgage desk, the corporate – and in the back of his mind he queries the rumour, whether it is credible, whether the market is reacting correctly even if it is true; and at a still more abstract level he sifts recent economic statistics to get a sense of the macro-economic reality, asking himself, is this economy strong enough to withstand higher interest rates? Layer upon layer of brain churns the data, searching for a pattern that feels right.
And then each layer of analysis turns up a match, like spinning wheels in a slot machine coming to rest one by one on a single fruit. One-two-three. Martin feels a gestalt-like switch in his body; the knot in his stomach unties and he senses a budding confidence. He has a hunch. A new interpretation tugs from the periphery of his consciousness, a mere glint of a possibility. No way this economy can take a large rate hike, let alone a series of hikes. No way this market should be scared even if there is a hike today, because it would reduce the chances of inflation, the bond market’s greatest enemy. Besides, this last move down and the desperate selling that drove it there felt like a last gasp, the panic move known in the market lexicon as the ‘capitulation trade’, when nervous managers, terrified of further losses, want out of their bonds at any price. When fear dominates, cool heads step in, and Martin is one of them. But he is not alone. In the past five minutes the market has started to trade differently. It is still pounded by large selling, in fact nothing but selling, and prices continue to spike down, but they bounce back quickly, like a trampoline. Something big, invisible, lurks in the depths, some immense client stepping in to buy every time the market dips, but who? Maybe Bank of China, maybe Bank of Japan, maybe the Kuwait Monetary Authority, who knows? But whoever it is, this is one large beast. Gwen has felt it too, and together she and Martin decide to hold any more long positions they buy from clients.
They start to see some buying, clients stepping in to nibble at the market. Before long it becomes apparent that the panic move down is over, and the market has returned to a normal battle between buyers and sellers. It is in these conditions that traders can make a fortune. Volatility is high, client volumes are large, and since the market is jumping around so much and uncertainty is so high, clients are not too demanding about the prices they receive. They want fast execution, and are willing to leave money on the table to get it. For example, in one trade, with the five-year bond trading at 100.16–18, an insurance company in Florida asks to sell $80 million, and Gwen bids 100.14 and buys them; a few minutes later another client asks to buy $100 million and she offers at 100.19 and gets lifted, making a quick $125,000. On a day like today this seesaw between clients buying and selling can go on for hours at time. Profit margins may be small, a cent here, half a cent the
re, but with the volumes across a bank amounting to tens, even hundreds of billions of dollars, they add up. The mighty edifice that is Wall Street was not built on the fortunes of flamboyant speculators, as myth would have it – it was built on pennies.
Just as valuable as the bid–offer spread the traders enjoy is the information they alone can access. Traders at the big banks see the largest client trades, and therefore know before the rest of the financial community where the smart money, the big money – the central banks, the hedge funds, oil money, large pension funds, the sovereign wealth funds – is going. This enables them to get there first. They can sell large blocks of bonds to their clients at market prices, and then buy them on the screens before the smaller banks and institutions figure out what is going on and why they are losing money. No one else in the world is privy to this fund of information, although the traders do share it with their big clients – especially the hedge funds they hope to work for one day – and so valuable is it that the big banks spend fortunes maintaining an extensive global sales force.
More and more traders across the floor, seeing buyers emerge, have adopted the same strategy as Martin and Gwen, building up a long position in bonds. Martin senses relief along the aisle. The traders are no longer battling for survival; they are warming to their game. Like a hockey team that has scored an important goal, the traders and salespeople feel a shift in spirit from defence to offence. This is the type of market traders dream of, one that draws them out of their fears and thoughts and preconceived ideas. Martin, Gwen, Logan, Scott and the other traders along the aisle no longer view the market’s volatility as a threat to fear, but as a challenge to embrace. They have entered the zone. When they are in this state, the pulses of information being shot at traders are welcome, the risks gladly embraced, the uncertainty craved like an exciting game. Here, at the peak of Berlyne’s hill, information comes freighted with excited expectation.
