Decomposing Credit & Systemic Fears

A useful measure of how to think about how the market prices two key "unknowns" -- idiosyncratic credit risk and system wide disturbance -- is to use the TED spreads. The TED spread can be created by trading Futures positions in US Treasuries and Eurodollar markets. Implicit in the prices quoted (via the IMM convention) are interest rates implied. So a Eurodollar quoted at 98, implies a rate of 100-98 = 2%. The USD TED Spreads are thus created by going long US Treasury futures and short Eurodollar futures -- thus creating a spread. For more details see here.

As of yesterday, the 3M TED spreads (for US, UK and Euro) have widened while the 6M TED spreads have reduced thee difference. In the short term, the market continues to price a worsening credit environment; while over the 6M period -- these spreads have declined, because the underlying trades are assumed to be liquid, well executed and easy to offload. In essence, the system is assumed to be working.

So, what to do if you believe that there is an extended stretch of trouble that the market is not pricing? i.e., Systemic crises is likely to worsen. You are then betting on the spreads to widen. Note that, TED = 3M Eurodollar - 3M Treasury. This can happen by Treasury yields falling, EuroDollar futures implied rates rising or both yields moving in opposite direction. Being pessimistic is equivalent to being long TED spreads, which equivalent to buying Treasury futures and short-selling Eurodollar futures.

If you are feeling optimistic about the economy at large, sell Treasury futures and buy Eurodollar futures...

As an aside, I read about Christian Siva-Jothy's monster trades post the first plane attack on 911, predictably he bet on yields on Eurodollars falling (and went long Eurodollar notes). I am not sure what the TED spreads did in those hours of 911... Any guesses?