The U.S. Treasury has released a report on the potential effects of a default on U.S. Treasuries. The key findings in the report are:
The United States has never defaulted on its obligations, and the U.S. dollar and Treasury securities are at the center of the international financial system. A default would be unprecedented and has the potential to be catastrophic: credit markets could freeze, the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world , and there might be a financial crisis and recession that could echo the events of 2008 or worse.
The S&P 500 index of equity prices fell about 17 percent in the period surrounding the 2011 debt limit debate and did not recover to its average over the first half of the year until into 2012.
One common measure of volatility or uncertainty in financial markets is the ― implied volatility of stock prices, measured by the VIX. The VIX jumped around the time of the 2011 debt ceiling impasse, roughly doubling, and remained elevated for months. Greater volatility can lead investors to pull back from any investment they perceive as risky, a development that tends to raise the cost of borrowing for households and businesses.
In 2011, corporate risk spreads on BBB -rated corporate debt jumped 56 basis points, and the wider spreads persisted into 2012. A portion of the widening in this risk spread likely reflects the sovereign debt crisis in Europe among other factors, which both increased corporate risks and pushed down Treasury yields.
A protracted debate about the debt ceiling could spark renewed financial market stress, and a fall in stock prices and wider credit spreads would depress spending from the private sector. In addition, increased uncertainty or reduced confidence could lead consumers to postpone purchases and businesses to postpone hiring and investments. A precise estimate of the effects is impossible, and the current situation is different than that of late 2011, yet economic theory and empirical evidence is clear about the direction of the effect: a large, adverse, and persistent financial shock like the one that began in late 2011 would result in a slower economy with less hiring and a higher unemployment rate than would otherwise be the case.
Their point is clear: a default would make 2007-2009 look like a test. Further, continued uncertainty depresses asset prices and therefore the broader economy. So what does the market think? Let's have a look:
First a look at U.S. default swaps:
From the chart, we can see that participants are hedging against a U.S. default. We are relatively well below 2011 levels and nowhere near the February 2009 levels. CDS is, in my opinion, not pricing a default.
The VIX is not showing that market participants are all that concerned about a default either.
And the S&P500 (NYSEARCA:SPY):
The S&P500, while down, is not forecasting a default either.
And finally credit spreads, as measured by the Markit CDX North America Investment Grade Index:
So where is the opportunity. Quite simply, to get long the U.S. dollar. The dollar has been abused since the taper, no taper, shutdown and ceiling worries came into play. Using the PowerShares DB U.S. Dollar Index Bullish Fund (NYSEARCA:UUP) as the best tradable proxy for the dollar against the currency basket, the move looks like:
PowerShares DB U.S. Dollar Index Bullish Fund is an exchange-traded fund incorporated in the USA. The Fund is designed to replicate being long the U.S. dollar against the following currencies: euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.
If you believe, as I do, that the U.S. will not allow a default, and the beltway will come to their senses (at least temporarily), then getting long the dollar will be a profitable trade.
A secondary trade can be getting long mortgages. The rationale: the reduction in growth and the uncertainty in the market will give the Fed pause when considering the timing of the taper. As well, the taper and its effects have been priced into the market and have also been reflected in the prices of mortgage related investments - yes, mREITs. I would view this as a decent trade with capital appreciation and cash flow as the objective. The prices and book values of these REITs have been punished by the market move. In response, they have begun de-levering and increasing their hedging activities. While both of these factors will weigh heavy on the dividend decision, even with another round of dividend cuts, the cash flow is attractive. For this trade, I would consider Two Harbors (NYSE:TWO) given their mix of agency and non-agency securities as well as their risk management or Agency mREITs MFA Financial (NYSE:MFA) or Western Asset Mortgage Capital Corp. (NYSE:WMC).
Two Harbors Investment Corp. focuses on investing in, financing, and managing residential mortgage-backed securities (RMBS), residential mortgage loans, and other financial assets. The company's target assets include agency RMBS collateralized by fixed rate mortgage loans, adjustable rate mortgage loans, hybrid mortgage loans, or derivatives; and non-agency RMBS collateralized by prime mortgage loans, Alt-A mortgage loans, pay-option ARM mortgage loans, and subprime mortgage loans. Its target assets also comprise prime nonconforming and credit sensitive residential mortgage loans; and other assets, such as asset backed securities and hedging transactions.
MFA Financial, Inc., invests in residential agency and non-agency mortgage-backed securities. Its MBS are secured by hybrid mortgages, adjustable-rate mortgages, and 15-year and longer term fixed-rate mortgages, as well as by mortgages that have interest rates that reset more frequently.
Western Asset Mortgage Capital Corp. invests in, finances, and manages primarily residential mortgage-backed securities that are issued or guaranteed by a U.S. Government agency or federally chartered corporation. The Company also invests commercial mortgage-backed and residential mortgage-backed securities guaranteed by the United States Government.
WMC data by YCharts
Bottom Line: Saber rattling and posturing in the beltway has created an opportunity. While there is obviously risk in these trade ideas, a portion of a portfolio can be utilized to take advantage of the opportunity. These are not "invest your life savings" ideas, rather tactical ideas that could be used with 5% - 10% of your portfolio depending on your risk tolerance.
Disclosure: I am long TWO, WMC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.