After having its sovereign debt downgraded to AA-Plus last summer for the first time, the US may be in for another downgraded either by Fitch or Moody’s by year’s end. That’s the stark forecast by Merrill Lynch Bank of America (NYSE:BAC). What would be the effect of this new downgrade on financial markets?
As was the case with the previous downgrades, some analysts believe that the new downgrade will have a minor effect on U.S. Treasuries, as was the case with Japanese government debt that continued to rally even after credit agencies downgraded it; and they may be right. But this isn’t a certain event, as the debt structure of the two countries is different, and given the huge rally in treasuries, it may catch many traders on the wrong side of the table.
Besides, some institutional investors aren't allowed to invest in debt that is less than AAA-graded, especially if it comes by all three agencies. So, the downgrade is expected to have a major negative effect on both bonds and stocks, at least for the short run. What should investors do, if this scenario becomes likely?
Here are four possible trades:
1. Buy an ETF that is short on U.S. treasuries like the ProShares UltraShort Lehman 20+ (NYSEARCA:TBT) or ProShares UltraShort Lehman 7-10(NYSEARCA:PST). The problem for investors, however, is that both funds bet against the daily price movements of U.S. treasuries, and therefore, they do not make good long-term bets.
2. Short iShares Barclays 20+ Year Treasury Bond (NYSEARCA:TLT). The problem again is that TLT is a bet on the daily price movements of US. Treasuries, and therefore, it isn’t a good long-term bet.
3. Buy protection. Short or buy puts on SPDR S&P 500 500 (NYSEARCA:SPY). The problem, however, is that the S&P 500 has had a big correction already. So investors may want to average into this trade rather than going outright into a major position. They may want to do the same with iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX)--Buy VXX or buy calls on VXX to bet on rising volatility.
4. Avoid precious metals, and precious metal ETFs like iShares Silver Trust(NYSEARCA:SLV), SPDR Gold Shares (NYSEARCA:GLD), and Freeport-McMoRan Copper and Gold (NYSE:FCX), as they may go either way. Another downgrade may raise fears of an impeding fiscal collapse, boosting gold prices. At the same time, rising long-term rates may raise recession fears, depressing gold prices.