Playing the Debt Crisis: Go Short but Anticipate a Rally

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Includes: TLT, UUP
by: Dana Blankenhorn

Go short, but watch for the reversal.

The debt crisis trade starts today. The surprisingly bad June unemployment report is the catalyst.

There are no important events ahead, save the August 2 deadline for some agreement to be reached that will allow the debt ceiling to be raised. So go short. Short anything that looks short-able. Short the whole U.S. government.

But don't go so short that you can't pull back. That's always the problem with these kinds of trades, the reversal, the snap-back, the relief rally.

Be certain of one thing. There will be such a rally.

If you're a regular at Seeking Alpha, Jim Farrish told you the play back in November. You bet against TLT, an ETF which tracks the value of Treasury debt with maturities of 20 years or higher. You can also play against UUP, which bets for the dollar.

You're playing against the dollar and for a rise in interest rates. But you might want to put in some stops, because once these trades reverse they will move very, very quickly.

This is, as they say, the biggest no-brainer in the history of earth. The President is a poker player. His friend in need, his ace under the table, is the 14th amendment language stating that the government must honor its debts. Letters from a Treasury Department lawyer notwithstanding.

It is in the interest of any good poker player to deny the hole card, to either pretend it's no help or pretend it's not there. The purpose of this winner's bluff is to raise the size of the pot, to get other players to raise, and raise again. It's theater. Washington loves theater.

Some Republicans, like Bruce Bartlett, are trying to warn their brethren that the President has this Ace in the hole, that the Constitution trumps everything. Even House Speaker Boehner is putting out the word that eventually his party must make a deal. His backing away from the table is an attempt to make the pot smaller.

The President insists he wants negotiations, holds out hope legislators can win nearly all their goals through negotiations, angers his party with this stance, and the clock keeps ticking.

Before the hole card can be turned over the stakes need to be at their maximum, which is where Wall Street comes in. The bond vigilantes have to spook buyers out of their safe haven before the President plays his hole card.

Traders need to believe that the government might really default before the Ace can be turned over profitably. Until they do, until government bond yields rocket upward, until serious short-term damage has been done, the pot's light.

Democrats spent a generation bemoaning the “Lucy and the football” nature of the place, as their legislative efforts to create change failed in the face of Republican Presidents. This has nothing to do with Republican vs. Democrat. It has to do with executive vs. legislature. The executive always wins.

So Washington will fret, and Wall Street will believe the threat, and only then can the crisis end.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.