How to Trade Both Sides of the Debt Crisis

by Michael Shulman | July 27, 2011 1:21 pm

The U.S.debt crisis is a very short-term, a near-term, a midterm and a long-term problem. And you can play it with trades to generate cash and profit or black swan trades that, in the event of a default, could generate early retirement.

Before we get to the trades, here is what you can expect:

Very Short Term

Forget your politics; the current behavior of the radical freshmen and their allies in the Republican caucus is comparable to the secessionist Democrats who gave us the Civil War. It is now clear they came toWashingtonto talk about ideology rather than govern.

The Republicans did this in the Gingrich era, shut down the government and lost the 1996 presidential election and the House. There is now a 1-in-3 chance of a default and more than a 50% chance there will be a credit ratings agency downgrade ofU.S.debt in the very short term.

Near Term

If there is a deal, it will be for the short term, one week to six months, and will a) keep the crisis brewing, and b) prompt a downgrade of the country’s AAA credit rating. (This is not my opinion – it is the publicly stated opinion of the credit ratings agencies.) This means ongoing uncertainty, a hit to markets of unknown force due to the ratings downgrade, and a slip from stagnation to out-and-out recession.


By midterm, I mean six months to the end of 2012. A downgrade and a market decline combined with increased interest rates and an economic downturn guarantees re-election for Barack Obama. Forget the nonsense of pinning the economy on him – two-thirds of people polled currently blame the Republicans for the crisis due to their intransigence. If the debt ceiling continues to be the primary issue in 2012, uncertainty will keep markets flat or down for the entire year.

And don’t forget thatGreecewill default very soon (but they will use a nicer word), and a big-timeGreecedefault will follow in 2012 or 2013. This is obviously not good the markets either.

A default could cause a sharp market decline with no Bernanke-driven rebound — he has no tools for this fight. At least 20%, and if financial markets melt in a similar fashion to the Lehman bankruptcy (a possibility if not a probability), a 50% haircut to the S&P 500, and we’re back to the post-Lehman crash lows.

Long Term

If there is a long-term deal, good times. Since there will be no big deal in the short term, the long term means a strong probability of a lower credit rating for the United States and slightly less — just slightly — less appetite for Treasurys among those who can buy non-AAA rated securities. This means higher interest rates, a reduction in real federal spending after interest payments, and slower economic growth.

It also means Bernanke will hold interest rates as low as they are now until he retires, they carry him out, or the Washington Nationals win the World Series.

Counter Argument

There is a counter argument to all this doom and gloom: Simply put, theUnited Statesis too big to fail, a credit downgrade is just noise and a default is a temporary event. This is half true — meaning at least 50% of traders feel this way right now. And 50% of me does, as well.

The Trades

There are two sets of trades here — for the 50% of you that think this is all going to go very badly, and trades for the 50% of you that think this will be a one-off event that might last a while, but is far smaller in impact than the post-Lehman Brothers bankruptcy crash.

‘It’s All Good’ Trades

Calls on the Precious Metal ETFs: Here I’m talking about the SPDR Gold Shares (NYSE:GLD[1]), iShares Siulver Trust (NYSE:SLV[2]) and the Market Vectors Gold Miners ETF (NYSE:GDX[3]). This is a strong play for the next one day to two years given technical and fundamental momentum. Many believe current monetary policy will lead to inflation — they are laughably wrong — but they want gold and silver. Silver is also an important metal in the production of medical treatments and electronics. Look at both short-term and long-term near-the-money call options.

Calls on TBT: The ProShares UltraShort 20+ Year Treasury (NYSE:TBT[4]) is the double-inverse ETF for the 10-year Treasury note. It goes up between 1.5% and 2% for every 1% the value of these bonds declines — and bonds decline in value when interest rates go up. Look at short-term calls that are just out of the money.

Calls on UUP: Right now, everyone is buying puts on the PowerShares DB US Dollar Index Bullish Fund (NYSE:UUP[5]) as it is expected that the U.S. dollar will fall in the event of a downgrade or default. I believe — and I am a contrarian — they have it wrong. If there is an event of some sort and interest rates rise, money will flow into Treasurys and strengthen the dollar. Look at short-term calls that are just out of the money.

Black Swan Trades

A black swan event is something that is unexpected (so this technically does not qualify) and seismic. Many professionals use them as hedges against events that move the markets 10% or more. If the event turns out to be a non-event, you will lose money, perhaps all of you have put in, on these trades. But if it all goes to hell in a handbasket, you will be sitting pretty.

Precious Metals: Look at far out-of-the-money calls that expire no later than September. Assume gold will go to $1,800 or more, and the GLD will go to $180-plus. And its cousins, the SLV and GDX, will also go much higher. Remember the previous high on SLV is around $50, and it is currently trading around $40.

The Indices: Markets could fall hard in the event of a crash and even a credit downgrade. Look at deep-out-of-the-money puts on the S&P 500 (SPX). With the S&P around 1,330, look at short-term puts that expire no later than September, that reflect a 20% drop in the index.

  1. GLD:
  2. SLV:
  3. GDX:
  4. TBT:
  5. UUP:

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