How to Trade the Debt Ceiling Crisis

by Michael Shulman | May 17, 2011 9:35 am

Is there a real debt crisis in the U.S., and if so, can it be traded?

The answer to the first question is yes and no, and the second is yes and maybe. Was I clear? No? OK, here goes. Keep in mind there are always opportunities for profit for options trading[1] investors.

IS THERE A REAL DEBT CRISIS?

YES. Congress, specifically the newer members of the Republican Party, are threatening to hold up approval of an increase in the debt limit for Uncle Sam until there are meaningful plans put in place to cut spending. Not cut the deficit but cut spending. After all, they say taxes are off the table.

I am not going to get into politics, but the discussions that include statements the debt ceiling should not be raised and it is “OK” if the US “temporarily” defaults on its sovereign debt are criminal.  A default by the US — this would happen if we couldn’t borrow enough to pay off past obligations that come due this summer — would make the post-Lehman crash in 2008 look like a bull market. A real default would cut stock indices by at least two thirds – an S&P 500 down as low as 400; it is 1340 and change right now.

NO. I believe there is a one in 10,000 chance this will happen. Speaker of the House John Boehner is a grown up, unlike many of his members, and is letting his newer members speak, and pandering to them for now, but he understands what would happen. That being said, he is going to play chicken far longer than I and anyone should prefer.

FACTS:

The theoretical date things get terrible is the first week of August — and the thing to watch is the interest rates on new 30-day bonds issued in July, although Treasury may try to avoid doing this.  The political class is now so used to fomenting crises for C-SPAN and fund raising they may take this out too close to the end game for comfort. You think not? The TARP did not pass the first time around — the market fell more than 800 points in a few nanoseconds — and the TARP passed Congress right after that. This would be far more dramatic.

CAN YOU TRADE THIS?

MAYBE. I believe the debt ceiling will be raised and the potential for trading this nonsense is based on how much Congress “plays chicken” with the debt ceiling. This trade is already taking shape, and is based on movements in interest rates — a crisis will spark in an increase in interest rates and that will hit the value of existing bonds. So “maybe” means the ceiling will be raised but the trade is in the buildup to Congressional action.

YES. If you believe the game of chicken will go too far and want to trade the buildup to what would be a real crisis, you need to look at options on ETFs for bonds and precious metals.  (You should probably be long precious metals anyway given the short-, mid- and long-term state of the world).

Here’s what will move as we near the deadline.

If you do any of this, play options no sooner than September. Find here a list of bond funds.[6]

What to do? The real trade is the build up to a crisis when you can play the game of chicken. But, if for some reason Congress loses its mind, refuses to raise the debt ceiling and the US defaults on its bonds, it’s early retirement for all of us.

Endnotes:
  1. options trading: http://investorplace.com/options-trading/
  2. TBT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TBT
  3. TLT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TLT
  4. GLD: http://studio-5.financialcontent.com/investplace/quote?Symbol=GLD
  5. SLV: http://studio-5.financialcontent.com/investplace/quote?Symbol=SLV
  6. Find here a list of bond funds.: http://etf.about.com/od/bondetfs/a/List_of_bond_etfs.htm

Source URL: http://investorplace.com/2011/05/how-to-trade-the-debt-ceiling-crisis-tlt-tbt-gld-slv/
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