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.

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?