null Episode 4: COVID-19
Double Take podcast

Episode 4: COVID-19

COVID-19 Double Take podcast Audio Equity Fixed Income Index
April 2020
Episode 4: COVID-19

Three expert views unpack the unprecedented events of the last three weeks and how market shocks of historic proportions are shaping the global trajectory.

Rafe Lewis: Hello and welcome to Double Take, the Mellon podcast for and by those who care deeply about the big themes and forces impacting the investment world. I'm Rafe Lewis, director of investigative investment research here at Mellon. Let's just start by saying that we're recording this episode of Double Take from the decidedly low-tech confines of our home offices. Thus, please excuse any audio imperfections, cat meows, dog barks, children yelling. With me is my trusty cohost and fellow investigative researcher, Jack Encarnacao. Jack, what say you?

Jack Encarnacao: Well, firstly, welcome to the brave new world, everybody, and I hope everyone is staying safe. Certainly, we here at Mellon are doing all we can to stay quarantined and keep others safe, but we're still trying to put out content that we hope can be useful and instructive in a volatile time like this. We've departed from our regularly scheduled episodes, as Rafe said, to bring you a special pandemic edition of Double Take. It'll be something of a triple take this time because joining us right off the top will be an old friend to the show. She just joined us for our in-depth discussion of gene therapy innovations last time. It's Mellon's biotech analyst Amanda Birdsey-Benson. She'll be discussing the prospects for treatments and vaccines for the coronavirus COVID-19.

Rafe: We'll also be hearing from Mellon Chief Economist and macro strategist Vincent Reinhart on the US and other governments' plans for salvaging the economy during this unprecedented pandemic.

Jack: Lastly, we'll hear some more stories truly from the front lines when we're joined by Mellon's Head of Trading and Trade Analytics, Dragan Skoko.

Rafe: But first, let's set the scene here for a moment. Since last we podcasted into your earbuds, the world has turned completely upside down, I would say. Markets have been in a near freefall, with intense volatility. Some massive spikes up as well. Bond ratings have been punctured. Life as we know it has ground to a near halt. So let's hear from Amanda on if and when we can see a light at the end of the pandemic tunnel here. Jack, let our good listeners hear about Amanda's bona fides.

Jack: Of course. Amanda holds a PhD in biochemistry from Dartmouth College and has been analyzing biotech stocks for about eight years. She is now Mellon's lead biotechnology research analyst. Amanda, welcome back.

Amanda Birdsey-Benson: Thanks. Thank you for having me.

Rafe: Oh, it's so great to have you, Amanda. Maybe I should be reluctant to mention, but Amanda also happens to be married to an immunologist, so that probably factors into her conversations at home as well. Let's just see how that impacts her answers. Sorry for airing the personal laundry here. But Amanda, give us a rundown of the latest state of technology for testing patients to detect the COVID-19 virus.

Amanda: Yeah. We started a little late out of the gates here in the US. I guess the CDC had a test and there was a problem with the negative control I believe with that test. Since then we've had a couple of companies, many actually, come forward with their own tests that are far faster, and that should help us going forward. But even now, we're still struggling with getting everybody tests that wants to be tested. Another problem that we're focusing on is we don't have enough swabs, and the turnaround times have been problematic as well.

Amanda: So there was a doc at MGH who mentioned a couple days ago that, they had maybe nine or 10 patients that were positive at the hospital, but they had 109 that they were quarantining, because they hadn't gotten the test results back. So that's 109 beds being taken up, and however many rounds of doctors coming in with their personal protective equipment that then needs to get basically discarded. So the turnaround times, the swabs and general lack of tests right now is still something we're struggling with.

Jack: And for those outside of Boston, where we're broadcasting from MGH, Mass General Hospital, in addition to the volume of cases here in our part of the country, we also of course, have some of the leading hospitals in the world. And so it's a really intense discussion locally right now around this stuff. Amanda, everyone's hoping that scientists can really quickly develop a vaccine to inoculate all of us against this terrible virus. Can you explain the efforts underway?

Amanda: So basically, we have two different baskets of approaches for treating COVID-19. We have the antivirals, which are trying to dampen the viral replication cycle. And that would be mostly for patients that are already sick, that already have COVID-19. And then we have the vaccination strategy which would be for you and I, hopefully it can protect us from ever getting COVID-19. On the antiviral side, this is a little bit ahead of the vaccines. We have a few drugs that are in the clinic right now with several robust trials being run, and we have good anecdotal evidence.

Amanda: There were some patients treated on the Diamond Princess cruise ship. They were probably going to die and in two weeks, actually none of them had died. And then we have a large generic drug that's also being investigated, and that's already approved for the treatment of malaria and lupus and arthritis. This is oral. So this means it could be made available for many more people out there. There's at least two generic companies that have stepped up to make several million tablets right now. So that is also being conducted in a large trial, and we should see data over the next two months out of both of these antiviral approaches.

Amanda: On the vaccination side, as I've said before, it's probably going to be a year and a half before we have a vaccine available for the general public. That being said, there's never been an issue that's brought everybody together like this. I've heard one person describe it as it's almost like we're building an airplane while we're flying it. That's definitely what it feels like. So there's a few different approaches being taken here. One is more of like the typical vaccination strategy, where you inject a patient with a protein or an mRNA that encodes for a protein, and then that patient's immune system kind of detects it and starts generating antibodies against it. What that does is once you have the antibodies, they bind to the actual virus and prevent it from getting into your cells where that's where it wants to go. It wants to get into the cells so that it can replicate.

Amanda: And so, we have a few different companies that are coming up with vaccination strategies. We might see early hints of safety data in the next month or so. But it is going to be a while before it's available for you or I. Now, healthcare providers may be able to get access to this sooner because we definitely need to protect them on the front lines. Now, the first scenario that I described is an active vaccination strategy. But we can also take a passive strategy by just giving you antibodies from say somebody that's already had the virus, or let's say we gave the virus to be infected on a mouse, a humanized mouse with a virus, and the mouse generated those antibodies. And so we can take those antibodies and then transfer them to you Jack. Your body would immediately be protected from the virus.

Jack: Sounds great.

Amanda: Yeah. But we don't really know how long that you'd be protected for. So that's something that we're investigating right now. But we're working as fast as we can, and I have pretty good hope that over the next few weeks, we'll have something available, at least on an antiviral side.

Rafe: Last question for you, Amanda. Just wondering, from everything you're seeing from either the FDA or other major regulatory bodies out there in the world, is there any reason to believe they're going to be allowing for a speedier trial process here or kind of a faster process for worrying about the safety and health side effects of these things just to get them out into the population?

Amanda: I mean, it can be sped up a little bit. It can be prioritized. You have to go through several series of interactions with the FDA to even get a trial up and running. And of course, these have all been kind of front lines there. And so, yes, we're speeding up that side, but some things you just can't speed up. You can't speed up toxicology studies in rats and mice, and you can't really speed up figuring out what dose you need. So we're doing it as fast as we can. These will probably be the fastest trials you've ever seen, but they're still going to take time.

Jack: Fastest trials we've ever seen. We just hope they're fast enough, of course. Amanda Birdsey-Benson, thank you so much for getting us started here in our special look at the COVID-19 pandemic. All the best to you and keep up the great work.

Amanda: Thank you.

Jack: Now that we have a solid footing on the efforts of the world scientific community to test, treat and hopefully cure COVID-19, let's dive into the government response to the economic havoc being wrought by the pandemic. Joining us by Skype is Mellon's Vincent Reinhart. Rafe, why don't you introduce Vincent to the folks.

Rafe: Aye aye. Jack, so Vincent has a long and illustrious career in economics. Here at Mellon, Vincent's responsible for developing views on the global economy, making relative value recommendations across global bond markets, currencies, sectors. Previously, he was the chief US economist, and a managing director at Morgan Stanley. And for the prior four years, he was a resident scholar at the American Enterprise Institute. And before that, and probably most pertinent to today's discussion, he worked in several roles at the Federal Reserve Bank for over 24 years, including Director of the Division of Monetary Affairs. He was also the secretary and economist of the Federal Open Market Committee. Vincent, welcome.

Vincent Reinhart: Thanks for having me. Hope to have a good conversation here because there's a lot to talk about.

Jack: Oh my goodness. 

Vincent: This is a massive real shock to the global economy. It's natural to think back to the last time we had a big shock, i.e., the financial crisis of 2008 and 2009. There are important similarities, policymakers. Got an idea of how you deal with both an adverse hit to the economy and help market functioning. But it's different in a couple ways. First, it's a real shock. I mean, the mitigation efforts to contain the spread of the coronavirus are disrupting economic activity. We're not letting workers get to their businesses, we're not getting people to get to the stores. So both supply and demand are contracting. At the end of the day, the Federal Reserve can't make any extra output. It can facilitate demand growth, or staunch the bleeding in demand. But Jay Powell, lowering interest rates doesn't really induce a heck of a lot more spending.

Vincent: Now, the second reason it's different as opposed to 2008 and 2009 is the global nature. Yes, it was a big shock in the financial crisis, but it was primarily advanced economies. Because it was advanced economies financial institutions that were highly levered to housing in advanced economies. In fact, emerging markets continued to expand. Far fewer of them were in recession, importantly because China did a massive fiscal stimulus that kept commodity prices from falling, that kept demand growth for the products of EMs expanding. This time, it's everybody. The last time we had both advanced economies and emerging market economies at risk really was the Great Depression. That's not encouraging.

Vincent: What about the policy response? Well, God-willing, this is a temporary shock. We will get through the pandemic. We've already seen what happens with the countries that were infected early. There is an inflection point, the virus gets into the community, but at some point there is a cessation of new cases, deaths top off, just look at the path for China. And encouraging, the path right now in the Lombardi part of Italy. I think markets are taking that as relatively good news.

Rafe: Vincent, can I ask you in terms of the structural difference, between what happened in '08 and '09, and now? Just looking at for example, right now it seems to me that when they're saying, "Only essential businesses can stay open," it seems like most B2B type businesses are being allowed to stay open. I'm not sure what kind of percentage of the economies that is. And then on top of that, compared to '08, '09, there is a lot more consumption and buying that goes on now from computers and online and from mobile, and I wonder how these differences matter this time around?

Vincent: Sure. I think it's important not to buy into the house forecasts that have massive contractions in economic activity into the second quarter, exactly for the reason you say. You got to remember that a significant fraction of consumption is basically made up in the national income accounts. Owners equivalent rent, your payments to health care, insurance, pensions, about two thirds of personal consumption expenditure are on railroad tracks. Yes, we're not eating out that's for sure, but we're substituting eating out for eating at home. And yes, restaurants have seen a cratering in their activity, but online providers are scaling up in terms of the people who process and deliver. So there is going to be some substitution away from personal contact to electronic contact, and that will cushion the decline in consumption.

Vincent: There is going to be a decline in consumption though, and it's going to hit particularly small businesses. Something like 45% of the American workforce works at places that have 250 employees or less. They typically don't have deep pockets. Their main source of capital is their goodwill. And it's tough to borrow against goodwill to tide yourself over. So expect a big increase in claims on unemployment. We saw the leading edge of that just a week ago, it will get worse from here. We think the unemployment rate will increase seven tenths of a percent in the month of March. And hence looking in the rear-view mirror, it will be in potentially up five percentage points after that or more. Real GDP will decline in the second quarter.

Vincent: The issue is, is the infection inflicting a V on aggregate supply? If that's the case, then you want a policy response that's also V shaped. You don't want to follow Rahm Emanuel's law that a crisis is a wonderful opportunity to put in permanent policy changes. You want to get income to households. You want to get income to small businesses as quickly as you can to tide them over. But you also want that to have a shelf life, i.e., you don't want to continue that aid and transfer when the supply fact is gone away. And that'll be tough in terms of the legislative response. Witness how much difficulty the Congress is having right now in terms of figuring out a stabilization package.

Jack: Here in the US, Vincent, we're seeing the Fed take what appear to be unprecedented moves to provide liquidity and stability to both the US and world markets. Can you please maybe for us compare what we're seeing from the Fed today and what we saw in bygone eras, the Bush, Obama years, for instance?

Vincent: Sure. The thing to recognize is once you've done unconventional policies, like buying a broader class of assets, creating facilities to land against collateral that the Federal Reserve had not previously accepted, you've made that conventional policy. And so an important part of what the Fed is doing is just expanding the scale and scope of what it did in 2008 and 2009. I think you want to put Fed policy into two buckets. The first is the traditional view, the Fed is a macro stabilizer. If there's an aggregate first hit to aggregate demand, you'll lower interest rates, you'll buy Treasury securities. You want to facilitate more accommodative stance of monetary policy and financial markets, i.e., the federal funds rates at zero, purchases of government securities are open-ended.

Vincent: However, for a supply shock, that doesn't get all that much traction. If the Treasury yield is already 85 basis points, how much benefit do you get from pushing it lower? Remember the counterfactual. Markets are better off that the Fed has eased, but it's not going to get demand growth. The second bucket is what the Fed is doing to preserve market functioning. If it is a V-shaped path for the infection, or the supply for aggregate demand, then what you don't want to do is have market participants freeze up on the downward leg as a V, and have to sell their assets at fire sale prices.

Vincent: Because if there's going to be an upward slope to the V, it really isn't a liquidity problem, not an insolvency problem. So the Fed is rolling out all these facilities where it's taking as collateral, assets that if firms needed to raise cash, they would have to sell into a declining market. Instead, they can present it to the Federal Reserve get subsidized lending rates, favorable assessment of their collateral value and tide them over for now. And that's what the asset-backed commercial paper facility is, the money market, mutual fund facility, primary dealer credit facility, the whole alphabet soup of what the Fed's doing right now.

Rafe: And when you look at that alphabet soup, when you look at these facilities that they're providing to kind of alleviate the illiquidity problem. In your estimation, as someone who kind of sat there at the Fed at one point, are these the adequate weapons? The bazooka everyone's talking about. Is this a big enough caliber weapon to deal with the scope and scale of this problem?

Vincent: I do regret that people go back to the old phraseology, because when Treasury Secretary Paulson talked about having a bazooka, it didn't really go off. It didn't work and they had to do more. I think that the Fed is quite willing to improvise. In the space of a week we've had a new facility on average every 18 hours, which is pretty remarkable. And the Fed has gone from policies defined in terms of quantity limits to open-ended policies. The Fed's done a lot. It has helped the functioning of investment grade credit markets for sure, through its willingness to lend against IG debt and a willingness to purchase that debt.

Vincent: However, you see the limits of government intervention, because they drew a boundary, IG not high yield. High yield markets are really suffering right now, because they're trading debt that isn't eligible collateral for the Fed, that isn't on the Fed's list of purchases. High yield investors are worried that as there are downgrades, more and more debt will migrate into their market and put more strains on it. So the issue going forward for the Fed is, how does it define the perimeters of its operations, its facilities in two dimensions.

Vincent: Number one is, who are the counterparties they're willing to deal with? That matters because essentially, in a crisis reserves get trapped at big banks. Big banks have to worry about capital, they have to worry about leverage. And it's a very uncertain environment, so they have to husband their resources. Meanwhile, most of them work with value at risk models that say the amount of your commitments should be proportional to the volatility in markets. Well, guess what? markets are extremely volatile. That's inherently a recipe for contracting risk taking. And so markets aren't functioning as well. The way the Fed can do that is just deal with more counterparties than just the big banks.

Vincent: And so they've expanded some ranges of facilities beyond the narrow set of primary dealers, the 25 or so firms that the Fed normally deals with in open market operations to all banks, and for some of the facilities to non-banks. If functioning improves enough, that should be enough. If not, they're going to have to expand the perimeter of that, of its operations to include more and more potential different counterparties. The other way to expand the perimeter of your facilities is by the type of assets you take. Like the example if they've done something new, they've shown a willingness to accept investment grade debt. If that's not enough, they may have to draw the line a little further out and accept high yield.

Vincent: It is conceivable although certainly way down on their list of what they'd like to do, would be even to transact in equities. Other central banks have done it, including the Bank of Japan. But from the Fed's perspective, the Bank of Japan is a scary example, because the Bank of Japan is like the top 10 owner of every large firm in Japan, because it's expanded its balance sheet so much.

Jack: Well, that would be certainly a brave new world if that were to take shape. But one thing we've seen out of the Fed that seems to be unusual, and maybe an extension and acknowledgement of what you said, Vincent, around banks being less risk just based on their prerogatives and based on their guidelines. We're used to regional small banks lending to small business Main Street. That's what we think of as the conduit for capital for folks that are hurting the most right now in the SMB category, yet we hear the Fed talk about a credit facility for Main Street. How unusual is that and does that portend a new way of looking at what the Fed is willing to do?

Vincent: It is different for sure. It's not different than the 30s and the 40s. Back then the Fed Reserve was dealing with a banking system that was significantly more disaggregated. It was all state line drawn banks. So we didn't have national banks. The Federal Reserve used one of its discount window authorities, which is called 13 in the Act to lend directly to smaller institutions. It's done it before, but recognize that there's an enormous staffing issue related to that. You lend to a big company, you can put a lot of reserves into the banking system, you can take a lot of suspect collateral off the market. When we're talking about mom-and-pop retailing, that's much harder.

Vincent: Going back to the earlier point, their main capital, what they have to support their lending is their goodwill. How do you evaluate goodwill on such a large scale frame? I suspect where the Fed would go would be essentially use the credit card institutions as their intermediary, i.e., encourage lending to small businesses or encourage lending to entities that plausibly can establish that their liquidity needs are because of the adverse effects of a government policy, mitigating the spread of the infection. And then the Fed can accept that pools of collateral taken off the bank, those intermediaries balance sheets, through some discount window facility. But those details are to be filled in. I think the reason we've heard about all the other facilities first is it's dealing with markets. The market for small business lending is just big, diverse and spread regionally.

Rafe: Well, Vincent, one of the things I think about when you talk about lending activity is that banks don't traditionally love very low interest environments like this. There was already speculation before the pandemic that we were headed to negative interest rates here in the United States. So can you factor that into the conversation a little bit, when we think about the kind of plummeting interest rates and the desire of banks to extend credit?

Vincent: Sure. So there's two parts to that. The one is macro accommodation. Is it possible the Fed would go to a negative policy rate like the European Central Bank has done, like the Bank of Japan, the Swiss National Bank has done, in order to lower market rates even more so as to provide support to financial markets. It's possible. I'm pretty sure that Federal Reserve officials do not like the idea of a negative deposit rate or a negative rate on reserves in the US for a few reasons. Reserves are basically captured on bank balance sheets. The amount of reserves outstanding is determined entirely by the Federal Reserve's balance sheet. If it's bought stuff, it paid for with reserves, and those reserves stay there unless the Fed takes them back.

Vincent: But that's the tax base essentially. When you turn your interest rate on reserves negative, you'll be taxing banks because they have to pay interest to the Fed for the privilege of holding reserves. It's not a great idea to tax banks at a time when they are capital constrained and already risk averse, and perhaps reluctant to lend. Moreover, intermediaries have to pass a tax on to their customers. Banks have two sets of customers, depositors and lenders. The way you'd pass the tax on to depositors is cut the deposit rate. But there the risk is banks will get disintermediated.

Vincent: In the US we have an enormous money market mutual fund industry. The concern is if you turn the interest rate on reserves negative, and you just see deposits and banks pass it on to depositors, you'd see big deposit flight. You'd be shrinking the banking system just when you wanted it to be supportive of activity. If banks tried to pass it on to lending rates, i.e they charge higher loan rates to make up for the tax they're paying the Fed, that's counterproductive to supporting activity. So I think that's last on the list, but it's been done in other places, so you can't rule it out.

Jack: If we're as bold, Vincent, at this juncture to look past this, to what the economic setup looks like on the other side of COVID-19, would you imagine that any of the things the Fed is doing and/or is likely to be compelled to do, will register as a permanent change and not something that just happened to get us through this rough patch, but really a redefining of the role they play in the US and global economy?

Vincent: I'd step back and think about policy in total. If it's a V-shaped shock to the economy, you want V-shaped accommodative policies in place, i.e., policies that get the aid, get the support to markets on the way down, but then go away on the way up. Now, we have a good example. The Fed did unconventional policies in 2008 and in 2009, and they set the minimum base for what we expected the Fed to do. So, unconventional policies became conventional. Now they've expanded the range of the things they do, it will be hard for the Fed to unwind that. It will be hard for the Fed, perhaps they can shut down lending facilities when it's no longer appropriate. They did that in '09 and '10.

Vincent: But when would they start unwinding the investment grade credit on their balance sheets? Some of the stuff will just roll off and the Fed can let it roll off. That's the advantage of holding commercial paper or asset-backed commercial paper or asset-backed securities. They have relatively short maturities. But some of the investment grade debt they're buying has a longer maturity. How's the Fed going to get out of that? With some difficulty, moreover, having essentially expanded the coverage of the waterfront this time, the next time they're going to have to go back there.

Rafe: But, Vincent, when you talk about temporary shock requires a temporary response, I guess the counter argument to that is that a lot of folks are pointing to a lot of the regulatory regimes that went into place after the last recession and issue, as the reason that the banks are in better shape this time around. I mean, is there something else on a policy level that could be done to stabilize the sector going forward so that we're in even better shape when the next pandemic comes or the next recession?

Vincent: The Fed has been stress testing big commercial banks since the financial crisis. That has clearly been helpful because it's made them put in place the business resiliency practices, it's made them think about how to deal with big shocks. It's required more capital. They've put on supplementary leverage ratios. This is now a stress test of the regulations we put in place. It seems like some of the regulations including the supplementary leverage ratio, where the big banks have to keep leverage relative to their overall capital below a certain limit, is part of the reason they are constrained in redistributing reserves. They want to be sure they don't hit that limit.

Vincent: And so part of what the Fed is doing with the other financial regulatory agencies is loosening up a little bit on those restrictions, on those requirements. They're also clearly tapping the shoulders of big banks to say, "Be more willing to go to the discount window. Be more willing on forbearance." And they're also telling their supervisors and the examiners, thousands of whom are in the field, "This isn't the time to look at the letter of the law, allow banks to be more flexible." I think the biggest takeaway is more likely to be on business resilience. Can you have everybody work from home? Do you have the facilities in place? Do you have the bandwidth to let everybody work from home? That will probably be the next push on regulation.

Rafe: The last question for you, Vincent. This has been fantastic. President Trump had already been putting a lot of pressure on the Fed before the pandemic. I'm just wondering what your view is about the kind of pressure they are under now and how that might manifest itself, either in, I don't know, rebelliousness or being even more accommodative of the chief executive.

Vincent: I would note that the tweets are asymmetric. We had a lot of ones when the president thought rates were too high complaining about Jerome. I haven't seen many tweets recently saying, "Way to go. Zero is a good place. Thank you for those facilities." The Fed is an apolitical institution. It doesn't respond to those sorts of special pleadings, but it's also working in Washington DC, it's got to worry about its legitimacy. At a time of national peril, you want to make sure that you have all hands on deck, and that's what the Fed's done. And so, it is conceivable that if the Fed probably rightly viewed itself as a little more at risk, it was a little more assertive to make sure that it was seen as in the front lines. And the Fed's moved faster than what you'd normally think a central bank will do, and faster than most of the rest of the apparatus of Washington DC.

Vincent: If you want to worry about medium term risks is, what happens when a V meets a capital gamma? A gamma in the Greek alphabet is an upside down down L, i.e., you have a V-shape adverse shock to the economy, and you put in place policies that are relatively more permanent, like we were talking about those facilities. What I would worry about is when we're on the upper part of the V, and the accommodation is still in place, and the Fed is reluctant to remove it, will market participants interpret that as being political, as being influenced by a president who has been very assertive in giving advice to the Fed, a president by the way at that time, who will be imminently running for re-election?

Jack: Lots of things to monitor in what should be fascinating, if not stressful, several weeks and months ahead. Vincent Reinhart, it was a real pleasure to have you with us. Thanks for shedding some light and setting some things in context for us on Double Take.

Vincent: Thanks for having me.

Jack: Okay, folks. So we've heard about the science and medical industry response to the pandemic. We've heard about the government response to the coronavirus and widespread shutdowns. Now, let's dial in to markets and how investors are dealing with the remarkable realities that we're now in. And to guide us on that journey, we have Dragan Skoko, Mellon's head of trading and trade analytics, and a veteran of the markets. Dragan, welcome.

Dragan Skoko: It's good to be here. Thank you for having me.

Rafe: Dragan, this is an unbelievable time it feels like to me. I mean, what we've seen in the past two, three weeks in the public markets has been astonishing. We've been totally whipsawed by record volumes, and on the other end of this spectrum, complete circuit breaker driven shut downs of trading, the closure of trading floors. You've been around the block when it comes to trading and equities and fixed income, put us in your shoes a little bit. When the markets first started to convulse during this pandemic, how challenging was it to execute in that environment?

Dragan: Sure. I think you set the stage right. We have been dealing with market shocks of historic proportions. Some find this market more difficult to trade than the 2008 crisis. Equity markets, we're seeing concurrent selling from asset managers dealing with client redemptions, repositioning and risk adjustments from options traders, CTAs, and risk parity traders, as well as deleveraging from the long-short and quant funds. Markets moved exceptionally fast, and as banks and non-bank market makers widened the spreads and basically stepped to the side as they managed their own risk, we sort of market-wise circuit breakers as you said, and the so called single stock LULDs being triggered.

Dragan: That discontinuity helps stabilize the equity markets, but brings upon other challenges for cross asset traders because the discontinuity itself is not coordinated. In various fixed income markets quality bids have been very hard to find. And again, the buy side community moves in unison. Non-bank market makers have no obligation and honestly no ability to maintain orderly markets. And the bank's capacity and their own risk appetite are limited as well. So you have markets that are either frozen or trading way off the marks. Market makers actually describe situations to us in which they provide an extraordinarily low bid to indicate no interest in transacting, and they see that bid getting hit. Not by a poorly behaved algo like we saw in equities and FX into 2008 or '10 or 2011, but by traders, who are force selling to meet redemptions and have no other choice.

Dragan: And as some of the markets turn up in response to a positive news cycle, we see similar dynamics. Although these rallies are quite helpful on the fixed income side in particular, is the help you get some sales done and improve the liquidity profile of the portfolios.

Jack: Really interesting. So Dragan, can you do us a favor and maybe compare what we've been seeing during this pandemic with what happened back in 2007, '08 with Lehman Brothers and Bear Stearns and the auto manufacturers were leading us really into the Great Recession?

Dragan: Yeah, sure. I never thought we'd go through something as drastic as the 2008 financial crisis again, particularly in trading. There are a lot of similarities in terms of how various markets are behaving. Certain markets froze up almost immediately. Market makers have stepped aside. Each of the crisis arose out of a period of stability and compressed volatility. And then there are also some important differences. The velocity of this crisis is much, much higher than what we saw in 2008. The root cause is very different. The banks find themselves in a much better starting position rate.

Dragan: The Fed and the Treasury are drawing from the 2008 experience. They now have some tools to consider that they didn't have at the onset of the 2008 crisis. And I would say that overall reception to their action is far more positive than it was in '08. Primarily because they helped bring us out of the crisis, and because we don't have the perception that they're once again bailing out banks. The perception this time is that they're here to combat a common enemy for all of us. Another interesting aspect today, I would say is the need to allow the staff to work from home. This would have been impossible in 2008, and has presented a unique and difficult challenge to the entire trading community today.

Dragan: The balance of participants is also quite different than it was in 2008. So ETFs were not as widely available as a trading tool in 2008, and passive participants were a much smaller part of the ecosystem. I will say that those are the major similarities and differences between those two periods.

Rafe: Dragan, can you dig a little deeper into that comment about the passive participants because we've seen they've gone from a relatively small fraction of the trading market to half of the assets in relatively short order. I mean, how is that affecting your day to day work as a guy who's overseeing active trading?

Dragan: Sure. There are a number of changes to the investment industry and also to the market structure of various asset classes, not just equities but various asset classes, that have come our way as passive investment products, and ETFs as an investment vehicle have grown in size.

Dragan: So to highlight just a few. Intraday volume patterns in equity markets have changed significantly. The last 30 minutes of trading, and the closing auction, are significantly more liquid, and less volatile, than the rest of the trading day. Although it's worth pointing out that volatility here in this last 30 minutes has been uncharacteristically high this month during the crisis, and this is the first time we've seen that in quite some time.

Dragan: Then, use of the sell-side access methods has shifted from cash desks to what's algos and program desks. Use of ETFs to help manage liquidity, gain exposure, and hedge risk has become a valuable tool in everybody's toolbox.

Rafe: Dragan, we're hearing about challenges in various segments of the fixed income markets in particular, and I'm wondering if you could discuss those challenges broadly, and how things have changed from the onset of this pandemic crisis until now?

Dragan: Sure. That's actually a very important question. Often equity markets get a lot of the airwaves and headlines, but I would say that the fixed income market as it was in 2008, is really the main attraction. It's really safe to say that every segment of the fixed income markets came under severe stress quickly. And so let's just focus on a few. The dollar funding complex which has shown signs of stress, even in 2019, it basically suffered immediately. So the repo markets, which are typically poorly understood yet play a critical function basically froze.

Dragan: So in the repo market, you have a bunch of participants that need to borrow money for one, three or six months, and as the Fed held the overnight rate at 1.5% going into this, and the market participants were pricing in a need for significantly lower rates in the future, that inverted the money market curve. And when the money market curve is inverted, the money market funds who would be the natural lenders in this space, were more enticed to hold cash, as the stated yield of that was better than holding something three to six months out.

Dragan: We noted pretty quickly as we watched this unfold, that three things needed to happen for this market to come back to life. The Fed needed to provide liquidity into the market, and they did that. They announced initially a 1.5 trillion [inaudible 00:56:36] operation program, then subsequently basically lifted any limits off of that. They needed to drop the interest rate to zero to help [inaudible 00:56:46] the money market curve, and to entice the money market funds to lend. They did that as well.

Dragan: Lastly, we need a concrete agreement between the Treasury, the Fed and the banks, with respect to regulatory ratios and other constraints that have prevented the banks from scaling up their balance sheets and being better delivery mechanisms of cash to the end users. As well as staking on some of those assets that the buy side needs to move off of their books to meet client redemptions. This part is yet to happen entirely. As we move from that complex say to the corporate bond market, their market is under stress as well, because there's no visibility into the economy. So the spreads in investment grade and high yield markets widened drastically. And on top of this, we saw a lot of primary issuance in investment grade market ironically, which not only further impacted the liquidity in the secondary market, but also led to the largest sell-outs in the US Treasuries.

Dragan: We saw futures in the long bond and the ultra long bond in the US have their worst ever days last week, prior to rebounding a bit. Now the Fed also stepped in here as well, providing liquidity in form of a sizable buyback program announced this week. Every other segment of the fixed income market experienced similar shocks, immunities, emerging markets, FX, high yield, and so on. This week, we are definitely seeing positive effects of Fed's and Treasury's activity. I would say that many of the markets have improved and are now functioning, not at a pre-crisis levels but traders are able to get things done. Spreads have tightened. There's more two way activity. We will really love to see less primary issuance in the IG market to give the secondary market a breather. We do think that this buyback program is going to be hugely helpful.

Jack: What are we seeing, Dragan, from the so called liquidity providers? Are they helping to make for orderly markets as it stands? Are the liquidity providers providing enough liquidity?

Dragan: Sure. That's a very good question as well. So activity in a period like this is largely driven by redemptions and risk adjustments by the buy side, almost regardless of the investment style. And so as I indicated earlier, there isn't as much too late trading is needed to dampen the volatility and to achieve a better spread. During the initial shock in an environment like this, we see systematic market makers step aside as their models need to adjust to the new environment. And those that manage their overall risk using covariance matrices purely based on past data, they have to step aside for even longer.

Dragan: As days went by, those market makers and those participants have come back in, although selectively so. On the bank side, I would say that the banks provided initial liquidity and stepped in and were a kind of that first resort of liquidity for the buy side, but they have to be mindful of their balance sheet and their own risk. So I would say initial reaction, non-bank market makers stepped aside, the banks were there, subsequently received more balance, but both non-bank and bank owned market making operations are certainly a lot more selective than they would be under normal market conditions.

Rafe: And again, folks, pardon any audio imperfections we have here. We're doing our best with Skype and WiFi to make this happen. So be patient, and hopefully the transcript posted on the website will help if you head over to Well, Dragan, I'm wondering do you see any permanent or long lasting change emerging from this pandemic in the way that big shops like Mellon do their trading going forward? I mean, maybe another way to put it is, what are the lessons learned so far?

Dragan: Sure. I'm not sure we are ready to answer this question yet, as the crisis is still playing out. But let me focus on a few unique aspects of the crisis from the market structure perspective. We've seen the various improvements and general maturation of the equity markets, have brought upon a level of stability to their market structure that is standing up to this stress test. So in spite of all the public criticism but I would say inaccurate descriptions of this market structure, it's showing to be exceptionally resilient.

Dragan: We see that in the fixed income markets, systematic pricing and the overall market structure are still not able to withstand the stresses that are brought upon in a situation like this. We also know that the size of their market and the much higher complexity of the investment products on the fixed income side and the magnitude of potential losses, make it a much more difficult market to fully automate and streamline. I will say that one particular unique aspect of our situation today is the implementation of business continuity programs.

Dragan: So if you think of trading, it's typically been on the cutting edge of technology. Traders are used to several large monitors, we measure latency of our trading applications and of our networks in nano and microseconds. We give them access to the entire network of dealers and counterparties with one or two presses of a button. And now industry-wide we have traders at home with fewer screens and at the mercy of their cable providers network, which they share with their entire neighborhood and often within their household, with spouses and children. And this without a doubt has impact on liquidity and I think presents even more of a challenge for the sell side than for the buy side. I'm not sure yet what solutions we see come out of this, but I imagine that work from home gets tested more rigorously and more often by most market participants.

Dragan: Also, I'm sure that the Fed and the end users would like to see the liquidity made available by the Fed reach the end users in a much more efficient manner. So we either have to get the banks enticed and enabled to scale up their balance sheets more effectively, or we have to find a way to disintermediate the banks in their process in a situation like this and provide more direct mechanisms. And what else? Lastly, I would say that we've seen dark pools. They're particularly focused on large block orders in US equities, keep up their market share. And this is typically not seen when the markets are dropping and volatility is high. I would say that's an interesting dynamic and I think a positive one for these types of venues.

Rafe: Why do you think that is, Dragan?

Dragan: I would say that some of the programs probably contained a lot of large holdings on behalf of institutional players, and as the ability of banks to commit capital to facilitate those large block trades, as that ability of the banks dropped due to their own balance sheet concerns, I think that the buy side traders, institutional traders looked to other means to effect such trades. And certainly, some of the trusted dark pools provide such a mechanism and they went into those dark pools to effect those trades.

Jack: A really excellent overview of what you've seen and what you've observed, Dragan. I wonder if you could just give us maybe a one personal anecdote as we go here, sort of when you realized that you were in for some unprecedented times. I mean, it became obvious from the news flow to people outside of the trading circles, but what was one of the first things perhaps you noticed on your terminal that told you that this was going to require some different moves than you were accustomed to really making?

Dragan: If I kind of think back to my chats, and notes, during the first kind of signs that the crisis was about to hit us, a few things stick out. Firstly, traders in our Hong Kong and San Fran offices were increasingly concerned about the pandemic the last two weeks in February. At the same time in equities realized an implied volatility, a spike quite a bit in the last five to six trading sessions in February. The dollar funding complex started showing signs of stress the first week of March, and the first two weekends in March grocery stores in New England went from being as busy as they are ahead of a major snow storm to being mobbed with lines snaking all the way to the doors. I would say that this combination of first signs of market stress, and clear signals that we were dealing with a health crisis that we hadn't seen before here in our lifetimes, tipped us that March was about to be a very challenging month.

Jack: You mentioned that Hong Kong trader in that first signal of stress, what was that conversation like with Hong Kong? Were they sensing that this is going where it's going, or was it kind of a more shorter-term panic that you heard?

Dragan: Yes. No, so in Hong Kong we have started taking measures against the virus, itself as early as late December and early January, but the increase in the dialogue with the Hong Kong traders, and their sharing of the local headlines really intensified in those last two weeks of February. Given the general measured nature of our traders who are pros in the seats that definitely felt like something was truly different this time around.

Rafe: Wow. And by the way, folks, just to point it out, while Jack and I are in the safe confines of our home, Dragan is over at Mellon, right now in the offices. He's been overseeing all the trading this whole time. We thank you for it, Dragan. We want you to stay safe. We want all of our listeners to stay safe and healthy. Please follow the social distancing protocols, and wash your hands, and tune in for our next episode at some point. Thank you so much.

Dragan: Thank you. It was great to talk to you guys, and we'll speak soon.


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