The Hour Between Dog and Wolf

by John Coates

  Indeed, if the demands are high, the outcomes uncertain and the potential rewards substantial, people rise to the challenge with heightened energy and excitement, and with a focused and all-consuming attention that blots out distractions and loses track of time, they enter a state often described by psychologists as flow. People fortunate enough to experience the euphoric state of flow – artists, athletes, mathematicians, others who merely love their jobs – come to live for these moments of heightened performance. With every system of their body switched on and working to perfection, Martin and Gwen feel alive as never before. They revel in their powers and glory in their expertise, life as intense as it gets. This is what they love, this job, this New York, this moment in March.

  At 1.45 Martin picks up the mic of the squawk box and provides a commentary for the sales force. His views are widely respected on the Street, and his commentaries give salespeople a pretence for calling clients and drumming up business.

  ‘OK, listen up!’ Martin begins. ‘We’ve all heard the rumours and seen the sell-off. We saw massive selling on the way down, but also a hell of a lot of buying down at the bottom, and from clients with very deep pockets. If I had to guess – and that’s what I’m paid to do – I’d say a lot of people along the Street got caught short by the bounce and still need to buy bonds. Barring a three-quarter-point rate hike, and no way in hell the Fed’s going to do that, I’d trade this market from the long side. Shen will give you our view on the Fed.’

  Shen is the bank’s resident economist, and he proceeds to give the bank’s official view, that they have always believed the Fed would not raise rates today. Having said that, they, like pretty well everyone else on the Street, may have missed one or two hints the Fed has dropped. Shen cannot therefore discount the possibility that the Fed will raise rates today, given its strongly stated disapproval of the developing bubble in stocks, but he is confident that it would not hike any more than half a point.

  By 2.10 trading on the screens dwindles. The floor goes quiet. Over the past two hours banks and clients alike have jostled for position, and most have now set their trades. All around the world, traders and investors wait for the announcement. An expectant hush descends on global markets.

  I must now try to explain what happens in the next few moments. At 2.14, Martin and Gwen lean into their screens, gaze steady, pupils dilated, their breathing rhythmic and deep, muscles coiled, body and brain fused for the impending action. When the announcement comes across the news wire they will, like tennis players returning serve, spring into action, buying or selling bonds on the screens, volleying client trades, making sense out of the unpredictable market moves; and their activity will most likely continue throughout the afternoon, and maybe into the Tokyo morning. They will thus need to sustain a full fight-or-flight response. But that is not what is happening right now, just moments before the announcement. What happens now is another reflex action, known as the orienting response. The orienting response is an involuntary wait-and-see reaction, and while in its grip our heart and lungs slow almost to a stop.

  There is no clear agreement among physiologists on why exactly this happens. When a gazelle stands motionless in the tall grass, hoping not to be noticed by a lion ambling by, its heart and lungs are similarly motionless. Should it be discovered, it instantly leaps into a sprint. But how does it do this? How do its heart and lungs rev up so quickly? It can take a few seconds for the fight-or-flight response to reach its maximum effect, so would it not make more sense for the gazelle, while waiting, to crank its heart and lungs up to full capacity before the lion notices it? Then when it needs to run there would be no delays.

  One explanation for the orienting response is that the heart and lungs slow in order to increase the size of their draw, so that when we do jump into action the lungs are full of air and the heart full of blood. This is undoubtedly true. But there may be another reason. When a gazelle stands motionless watching a nearby lion, when a sprinter crouches at the starting line, when a goalkeeper prepares to defend a penalty kick, and when Martin and Gwen sit motionless before the Fed announcement, their bodies are indeed preparing the fight-or-flight response. They are, all of them, geared up and ready to go. Just not yet. For their heart and lungs are being held back, like an attack dog straining on a leash, by their vagus nerve.

  During the orienting response both the fight-or-flight and the rest-and-digest nervous systems are activated at the same time. When this happens our body is fully prepared for a quick sprint or a fight to the finish, but it is being restrained by what Stephen Porges, of the University of Illinois at Chicago, calls the vagal brake. At this point your body resembles a drag-racing car at the starting line: it locks its front brakes but guns its engine and spins its back tires, burning rubber and shooting out flames, until at the green light the driver merely releases the brake, and the car rockets down the track. The principle here is that the car accelerates far faster by releasing the brake on an already revving engine than it does by stepping on the gas and initiating acceleration. Much the same thing seems to happen in your body. The vagus, a powerful and fast-acting nerve, restrains the fight-or-flight response, allowing blood pressure and circulating levels of adrenalin to build up, and then releases its brake when the news comes out, instantaneously bringing heart and lungs to full speed.

  2.15 p.m. A single line prints out across the news wire. A brief pause, then Shen yells over the squawk, ‘A quarter point! The Fed raises rates a quarter of a per cent.’ The floor takes a moment to digest the news. Another line of print follows, containing the text of the Fed’s announcement and its reasons for acting, saying in effect that it remains vigilant about excesses in the stock market. Then the vacuum created by the momentary confusion fills with an explosion of activity. Vagus nerves across the globe release their brakes, and everyone starts screaming at once. The screens flicker with prices, and the squawk jumps to life with trades flooding in from clients, some selling, others buying, some of them the very clients who were desperate to sell this morning. There is utter confusion. The Fed has indeed raised rates, when few people were expecting it to, and that brute fact is the first to register. The market trades down, with the ten-year dropping an instantaneous half-point, but without much volume and not a lot of trades taking place. Merely a kneejerk reaction.

  But then the more considered response asserts itself – a quarter point? That’s nothing. It’s not three quarters of a point, nor even half a point. What’s all this tough talk about reining in the stock market? A quarter point? That’s nothing! A slap on the wrist. This Fed is not putting up a fight; it is not going to back up its tough talk with aggressive rate hikes, not like Paul Volker did back in the early eighties when he hiked rates to over 20 per cent. Now that was one tough banker. But a quarter point? Ha!

  The market breathes a collective sigh of relief, and then it is off to the races. Stocks, emboldened by the news, rally a quick 200 points, and the bond market regains all its losses for the day and then continues to rally. The trades now coming in through the sales desks are large, non-stop, and all on the buy side. Martin and Gwen use these requests for bonds as a chance to scale out of their remaining long position, bought almost two points below the current market price of 101.16 on the ten-year. The fun continues all afternoon, and towards the end of the day Ash strolls by and whispers to Martin and Gwen that the floor is on track for a great day. The Treasury desk, together with its satellite desks such as Treasury bills and government agencies, looks as if it will haul in almost $12 million.

  The Fed has now lost its power to scare. In its defence it has to be said that this loss of credibility is not entirely the Fed’s fault. Central banks face a near-impossible task when confronted by irrational exuberance, for at times like these controlling the market is like herding schoolchildren on a sugar high. Besides, if it raises rates enough to stop a stock market bubble, it could just as easily kill the economy. This is a very real risk, for when a market is aflame and maddening for pro
fits, raising rates a percentage point or two may have very little effect on the market, but would have an enormous impact on other businesses that depend on borrowed money, like manufacturing and utilities. If investors think the latest tech stocks, for instance, will prove to be the next IBM or Microsoft, they are not going to be dissuaded by a couple of per cent of extra interest they could earn on bank deposits. And that is precisely the mentality that has taken root in the markets.

  The seeds have been sown for a good bonus season. At the end of the day traders on a high float off the trading floor and head out to celebrate their triumphs with martinis, Nouveau Mexique and a late night in clubs throughout SoHo and Tribeca, neighbourhoods where the myth of Bohemia lives on even though the arts have long since been killed off by the Midas touch of Wall Street. Logan, hoisting his gym bag, announces confidently to a couple of salespeople lingering at their desks that nothing stands in the way of the Dow reaching 36,000.

  SIX

  The Fuel of Exuberance

  As March slips away and winter’s chill lifts, a spirit of youthfulness descends on Wall Street. With the Fed’s voice of authority all but silenced, the markets take on the appearance of an unsupervised playground. A bull market over the past two years may have taken stocks up 40 per cent and bonds about 20 per cent, but traders and investors believe this is just the beginning. With wild-eyed enthusiasm they conclude that a historic epoch, amounting to nothing less than a renaissance for the American economy, with permanently high growth rates and low inflation, is dawning, so bonds and stocks caper from high to high. News, no matter what its content, arrives with the breathless promise of unparalleled opportunity. Financial journalists warn investors against dithering, and declare that now is seed time in the fields of investment.

  When markets are in this giddy state, money rains down upon Wall Street. Every department of an investment bank, no matter if it is directly involved in the rallying markets or not, starts to report record profits. The securities that banks underwrite – the stocks, the corporate and mortgage-backed bonds – inevitably rally in price, so the banks make a fortune on any unsold inventories. And clients, the real money behind the markets, sit on assets that have increased dramatically in value, feel successful, so they become less aggressive in the prices they demand from Wall Street, leaving money scattered on the table. The extra margins made on client transactions can add up to a record year and massive bonuses for the bankers.

  With these outsized profits comes an irresistible urge among traders to increase the amount of risk they take. Where once a trader may have been comfortable trading $100 million bonds, he now trades $200 million, even $1 billion. And with these increased position sizes, coupled with strongly rallying markets, come unexpectedly large trading results, known in banks as the traders’ P&L, short for profit and loss statement. Where once a trader may have averaged a P&L of $250,000 per day, he now posts $375,000. The difference, should it be maintained over the 230-odd trading days in the average banker’s year, adds up to an extra $29 million in P&L, and maybe an extra $3 million in bonus.

  This upward drift in risk has occurred in most bull markets, but during one in particular it assumed well-nigh incredible proportions. During the recent housing bubble, roughly between 2002 and 2006, the financial world experienced nothing short of a hyperinflation. Before that time, during the 1990s, a golden boy on Wall Street might have traded a risk-weighted equivalent up to $500 million ten-years, attained P&Ls in the $30–50 million range, and been paid bonuses in the $1–3 million range, the real stars up to $5 million. Yet during the noughties, only a few years later, it was as if the financial world had added a decimal point to every number it dealt with, to position sizes, P&Ls and bonuses, which could now amount to over $50 million. I had been quite successful as a trader, and was accustomed to taking big risks, executing what at the time were some of the largest Eurodollar options trades on the Chicago Mercantile Exchange, but when I visited my old haunts in 2005 I barely recognised this new world. I felt like a grandfather recounting war stories from the days of cavalry charges, and receiving patronising smiles in return. But most sensible observers thought the risks being taken during the housing bubble were dangerous and ill-conceived. Tragically, they were right.

  While they last, though, bubbles like these can be fun. Unexpectedly large P&L emerging from greater than usual risk-taking is precisely the kind of situation that causes dopamine to surge into the nucleus accumbens, this narcotic most likely providing traders with the euphoric hit they enjoy during bull markets. But as the rally progresses, traders feel something else added to the mix, something more profound, more physical, like the rumble of some large engine switching on. For as profits rise, so too does testosterone. In fact, the two systems, the dopamine and the testosterone, are thought to work synergistically, with testosterone achieving its exciting effects largely by increasing dopamine in the nucleus accumbens, testosterone constituting the bass line of euphoria, dopamine the treble. Indeed, some evidence suggests that sex steroids such as testosterone may sensitise the brain to the effects of dopamine, making all rewards, from winning in sport, to victory in battle, to a large P&L, that much more thrilling; further evidence even suggests that steroids can be addictive.

  Testosterone, being a steroid hormone, works on a slower time scale than most molecules we have looked at. Unlike adrenalin, for example, which is pre-produced and stored in little pouches called vesicles, waiting to be released, steroids cannot be stored. Steroids are molecules that can cross cell membranes, even permeate skin (many steroids, such as testosterone, are applied as a gel) or penetrate the rubber gloves of lab technicians. Trying to hoard steroid molecules in a vesicle would be like trying to lock ghosts in a room – they would just drift through the cell walls. As a result they are produced only when needed, and then released into the blood, a time-consuming process. So the hormone signalling process, from hypothalamus to the production of steroid hormone, takes up to fifteen minutes just to get started.

  It takes even longer for steroids to take effect – hours, even days. The process may be slow, but the way steroids work is unique in the human body. They cross membranes, enter the cell nucleus, and cause gene transcription. In other words, steroids cause proteins, the building blocks of the body, to be manufactured. Furthermore, unlike other hormones which generally have effects localised to one or two tissues, steroids have receptors in almost every nucleated cell in the body. All these properties of steroids give you an inkling of their power. A single steroid like testosterone can cause a bewildering suite of physiological changes, building up bone density and lean-muscle mass, increasing haemoglobin and clotting agents in your blood, heightening mood, tormenting you with sexual fantasy, and tilting behaviour towards greater risk-taking. By doing so, testosterone orchestrates a focused and coordinated physical response to the competition and opportunity at hand. So during a bull market traders feel a deeper, more far-reaching transformation as the big engines of their physiology start to turbocharge their risk-taking.

  HOW MEN ARE MADE

  It can be difficult to view testosterone as a molecule, and a subject fit for serious scientific and medical research, because it comes shrouded in myth and cliché. The mere mention of the word seems enough to dispel any air of scientific objectivity. Since the early days of research into sex hormones the findings have too easily slipped out of the hands of scientists and clinicians and into the hands of quacks, who claimed they had bottled the fountain of youth, the ultimate aphrodisiac, the magic potion, like that possessed by the Gauls in the Asterix comic books, which promises superhuman powers on the field of battle. Unfortunately, many of the scientists who discovered this molecule contributed to the fog of hype shrouding it.

  In 1889 a French-American neurologist by the name of Charles Edward Brown-Séquard mixed up a witches’ brew from the testicles of dogs and guinea pigs. Brown-Séquard was a well-respected medic, and to this day a disorder of the nervous system he identified bears his n
ame; but when this 72-year-old scientist downed his own concoction of animal testicles he lost all scientific impartiality, claiming to have found a ‘rejuvenating elixir’ and proudly confiding to an audience in Paris that just that day he had ‘paid a visit’ to his wife. It is now thought that the virility of which he boasted was largely the result of a placebo effect, but his pronouncements stamped research into hormones in general, and testosterone in particular, from that day forth with crazed and extravagant expectations. Later, in the 1920s and 30s, the search for the active ingredient in animal testicles turned into something of an arms race, and was joined by scientists around the world. Research into hormones at this time seemed to hold out the promise of a superhuman life through chemistry. So hot was this research that it showed up in magazines and popular culture. Noël Coward, the master of the drawing-room comedy, picked up on this chatter; and in his 1932 play Design for Living has one character, Ernest, say, ‘I wish you’d tell me what’s upsetting you,’ to which he receives the reply, ‘Glands, I expect. Everything’s glandular. I read a book about it the other day.’

  It was in the previous year, 1931, that the first androgen – the class of steroid to which testosterone belongs – was isolated. A German scientist named Adolf Butenandt managed to extract 50 milligrams of androsterone, a weak form of testosterone, from 25,000 litres of urine donated by a police barracks in Berlin. He and others believed this chemical had important medical and commercial applications, but there had to be a better way of manufacturing it. Pharmaceutical companies devoted a great deal of time and money trying to synthesise the hormone from its mother molecule, cholesterol, something Butenandt and a Croatian scientist named Leopold Ružicka succeeded in doing in 1935. For their efforts they were jointly awarded the Nobel Prize for chemistry in 1939, achieving the acme of scientific respectability. Yet the scientific breakthrough continued to be accompanied by breathless hype: when describing testosterone to the Nobel Committee, Butenandt exclaimed, ‘Dynamite, gentlemen, it is pure dynamite!’