Rethinking the short sentiment on USD...

Leveraging refers to the simple act of borrowing X USD on the basis of the collateral of Y USD, such that X >> Y. So, X/Y = m refers to the leverage ratio at play. This ratio is assumed to be "stable" over the life time of a trade. However, as the net value of Y as measured in the market reduces, the leverage factor m increases. It is clear over the past year or so, banks have been actively involved in an effort to deleverage. The consequences are unclear in the long run - however, there seems to be emerging consensus that the aftereffects of this are likely to be significant. The effects of this reduction in leverage in the FX market is particularly interesting and complex. The order of complexity is furthered by the squeeze in the credit market. While the sentiment on the US economy is remarkably short -- the question regarding the USD is more complex.

One, particular confluence of credit and FX markets is the freeze up in the lending markets. In a fine essay by Thomas Stolper and others - they hint at the mechanics and the consequences of this relationship. Most banks have short dated FX obligations and longer dated domestic currency obligations. As the overseas short term lending markets freeze -- we get banks scrambling to find assets to pay out their obligations. Since most central bank lending mechanisms only lend in their domestic currencies -- most banks are forced to borrow domestically, convert that into the foreign currency and payout. The dollar denominated debts are the highest in the world, followed by Euro denominated and so on. So, as the US lending market freezes - one should the rising demand in the USD (as counterintuitive as it might seem).

However, this is one piece of the puzzle. The trader is only concerned with the net flow of dollars and changes in value - however, it is important to keep in mind the market imperfection (frozen credit markets) work its way through structural constrains.

USD vs Other Major Trading Currencies

In the picture above, I have plotted three weighted indices against the US$. (The weights and their calculations are given here.)

• Major Currencies: The indices in pink are a weighted average of Euro, CAD, YEN, GBP, CHF, AUD, SKK.
• Other Important Trading Partners: The indices in yellow are a weighted average of China, Mexico, Korea, Taiwan, HK, Malaysia, Singapore, BRL, Thai, India, Philippines, Israel, Indonesia, Russia, Saudi Arabia, Chile, Argentina, Colombia, Venezuela.
• Broad: The indices in blue are the entire basket of the two.

These countries have been selected as those that have more than ½ % in 2003 in either exports or imports. The first group (pink) is those currencies that are traded extensively outside their domicile. The second group isn’t traded extensively outside their own markets.

What is most amazing in these numbers is the presence of clear volatility regimes in place. The daily standard deviation of these indices are given here:

Dates	Broad Index	Major Currencies	OITP
2nd Jan ’07 to 16th Mar ‘07	0.357%	0.612%	0.230%
19th Mar ’07 to 19th Jun ‘07	0.766%	0.933%	0.646%
20th Jun’07 to 19th Oct ‘07	1.261%	1.853%	0.792%

Some conclusions:

1. The credit-induced crises of confidence have led to increased volatility in the FX markets.
2. The broad reaction has been – flight to safety. i.e., with respect to the Major currencies, the USD has been a “risky” holding. However with respect to the OITP, the USD depreciation has been lesser than expected – partly because the USD continues to be seen, on average, as a “safe” currency.
3. The OITP depreciation masks wide variation – where Venezuela has done substantially differently than India against USD.
4. Coupled with G7 consensus that Asian currencies should be “allowed” to get stronger – the OITP will be where the most diverse kind of action will be.

What does this portend for the future? My guess is that till the US economy picks up – the dollar slide against the Majors will continue. This is further aided by the Treasury’s policy of letting the dollar slide. The coming revaluation of the yuan will make this a really interesting group to think about. Need to think about this a bit more.