The Trades to Make if the Fed Bails Out State Governments

The Trade for if the States Get Bailed Out

In the United States, state and local governments across the country are experiencing similar debt and budget deficits that the individuals, organizations, and federal government are facing.

In the grand scheme of things, I think we will see a significant amount of risk being transferred to the federal government; in other words, I expect the federal government to quot;bailout" individuals, organizations, and state and local governments. I view this as one of the major economic shifts going on that the market has not fully priced in yet.

So what's the trade?

If we expect risk to be transferred from municipal bonds to Treasury bonds, we can look to buy MUB -- an ETF corresponding to the S&P National Municipal Bond Index -- while also buying TBT, an ETF inversely correlated to 20+ year Treasury bonds.

Timing is always the issue, of course. One indicator we may find to lead the way would be CXA, an ETF tracking municipal bonds in California. As one of the largest economies within the United States, it can be seen as an indication of where the country is headed. Here are some key insights:

• Goldman has been selling California bonds.
• Economist Mike Shedlock has been tracking the implosion of California -- see his previous coverage from a month ago.
• Welfare checks will be suspended effective February 1.

Let's look at the chart.

click to enlarge

The purple and yellow candles are CXA; the red and green are MUB, while TLT is blue and gray. If a sizable bailout does occur and the market has not priced this in, it would be a transfer of risk from the states to the federal government, and thus from CXA and MUB to TLT. We would then expect to see the prices converge. If California is a leading indicator, we may expect to see CXA pave the way.

Other Considerations

There is a question of the legality of the federal government assuming responsibility for the state governments. Thus far the Federal Reserve's bailouts have not been questioned, and thus a precedence of sorts has been set. States have resisted Federal mandates before, so the issue of states' rights vs. federal rights may arise again, and may impact CXA, MUB, and TBT as well as other ETFs and investment opportunities.

Comments

[skwestorange:]

Don't you think that much of this anticipated risk transfer has been priced in as shown in your charts by the significant recovery off the lows in both MUB and CXA? I am not sure that the upside from here will be worth it.

Jan 25 11:56 AM

[whisperonth...:]

If we bail out all the states, those with high taxes will feel righteous and "know" that their policies were fair and right, while those with lower taxes will get stronger. I don't think bailing out the states is the right thing. Refinancing the mortgages and making people pay for their loans will strengthen both their credit ratings and the banks' financial status, which in turn will help each state become stronger. Cutting business taxes will help the businesses expand and hire more people. Cutting welfare benefits or at least putting some strong restrictions on it will help force some of the slackers back to work. Cutting income taxes will provide more funds for people to spend, increasing local tax revenue, which will in turn help the states become stronger. Throwing money at a problem has never made the problem go away. Fixing the problem is the only way it will work.

Jan 25 01:41 PM

[HiSpeed:]

The People's Socialist Republic of California needs to make cuts in what it's paying out instead of just promising everyone huge benefits packages and expecting the market to ramp 10% or more per just to cover it.

Normal households need to balance their budgets or end up bankrupt; the States need to do the same.

Jan 25 02:56 PM

[know nothing:]

It's not just California, It's been suggested that 45 out of 50 states are in trouble! The tax payers are just begging to help all the states in need,so we'll take are I.O.U's for tax rebates and like it, you haven't seen anything yet!!!!! The tax payers are about to get the shaft once again!! More bailout money is already being talked about.. It seems 825 billion is not enough.... All you hear the politicians saying is "WE GOT TO GET THIS ECONOMY MOVING" It seems they leave out " at any and all costs" Our poor children and grand children and great grand children................. Round and round we go where we stop noone knows.

Jan 26 08:24 AM

[henarl:]

The politicians, and the bureaucrats, will always do whatever they can to make the voters and campaign contributers happy during their watch and shift the costs out in time for somebody else to worry about. Right now they are eager to fix all of our economic problems, no matter the cost, and hope that inflation will make it cheaper for later generations to pay the bill. Growth and inflation are necessary for our system to survive.

Jan 26 09:58 AM

[xom-only:]

do you think the bailout of the states comes before the bailout of mortgage holders?

Jan 26 12:59 PM

[doubleguns:]

Bailing out the states just leads to more rediculous spending proposals by the states. Poor states tax payers now will get to pay for the excesses of states that have rediculous spending programs. Why should poor taxpayer pay for californias extreamly generous spending plans. Californians need to pay for california since they get the benefits not some poor taxpayer in Oklahoma just getting by. More of the rich getting richer but this time its the rich states bleeding the poor from other states.

Jan 26 02:23 PM

[Roberm73:]

While I hate to say it, I think we will get round one of bailouts for the states. So I like the trade and it matchs what PIMCO has been saying.

Jan 26 03:12 PM