How to take advantage of the US debt crisis

Jul 29, 2011

You might have noticed by now that I have something of a bearish bent.

But even with the stock markets tumbling around us, I just can't get worried about this US debt ceiling business.

Why? Because it's a tawdry little pantomime. Nothing more.

Politicians in the US are focused on next year's election. They want to gain as much political capital from this situation as they possibly can.

So it's all about goodies and baddies. The winner is the party who can persuade the majority of the audience - the voters - that the other party are the baddies.

But beyond all the noise, the impact of this fight will be very short-term. The good news is that you can take advantage of the hysteria in the meantime.

A compromise will be found

As I mentioned on Tuesday, the Republicans want to make sure that there is another vote on the debt ceiling before the election, so they can make the Democrats look like spendthrifts. So they want to raise the ceiling by a trillion dollars.

The Democrats want the next vote pushed out to beyond the election date. So they want to raise the debt ceiling by $2.4 trillion.

Politicians being politicians, the decision will go to the wire. And it may go beyond the 2 August deadline, depending on how much slack there really is in the system.

But a compromise will be reached. The US isn't going to default on its debts, at least, not like this.

The way I see it, the Republicans are the ones who are in the toughest spot here. If the stock market collapses, or this default debate demonstrably hurts the US economy, they're the ones who are most likely to get the blame. So if they want to hang on to the moral high ground, they have to take what they can get and do a deal.

If they don't, it'll be very easy for the Democrats to paint themselves as the reasonable party - the ‘goodies'. So I reckon a deal will be done before long.

What if the US loses its AAA rating?

But what about the AAA rating? What if the US loses that?

Again, I just can't get too worried about this. This is not like sub-prime, or the eurozone.

Yes, lots of people hold Treasuries. But unlike with bundles of sub-prime loans, or peripheral eurozone debt, they know exactly what they are holding. With sub-prime, all investors knew was that their AAA-rated debts had suddenly stopped paying out, and so anyone holding it might be bankrupt.

As for eurozone peripheral debt, it's clear that the issuers - Greece for example - are bust. The uncertainty lies over whether or not someone else - Germany for example - will pay the debt for them, or how big the haircut will be.

A US treasury, on the other hand, is an IOU from the world's biggest economy. It's not an unknown quantity. And while the world's biggest economy is certainly not at its strongest, it is not going to turn around and stiff its creditors in any meaningful sense in the next six months.

In the long run, it may inflate its way out of debt, certainly. And there's no way on this earth that I would lend to the US at current rates of interest. But I've been saying that for quite some time, so nothing substantive has changed.

As Sean Corrigan puts it in his latest note from Diapason Commodities Management, "Circumstances do differ between the two, but those tempted to take the government's alarmism to heart might console themselves with the observation that Japan has sold ten-year debt at an average nominal 1.5% since it lost its first AAA rating in 1998, as compared to 4.5% in the prior period when it was thought to be on the verge of taking over the world".

What does this mean for investors?

Our view that the US dollar is set to rally was clearly a little premature. (My own bet against the Aussie dollar certainly was, although I managed to avoid any drastic losses, partly thanks to picking up tips from John C Burford's free spread betting email, MoneyWeek Trader).

But the more I think about it, the more I think that any resolution to this issue will see a rebound in the US currency. You just have to look at the various relief rallies in the euro to see what has happened there every time a new sticking plaster is applied to its problems.

Also, any deal reached on the debt ceiling should, technically speaking, be a mild improvement on the US's current spending path. Sure, it's going to take a lot more than a couple of trillion here and there to save the US from bankruptcy. But at the margin, the idea of spending cuts should be good news for the dollar, not bad news.

Moreover, I reckon we'll be back to worrying about the euro earlier than the market expects (that's just a hunch, but we're already seeing renewed fears over the likes of Cyprus). So all in all, I suspect this is going to look like a storm in a teacup within a few months.

Now, as I said above, this is still likely to go to the wire. And we may well get a big market panic before there is a resolution. But I think it'll be short-lived. And so I'd get your watch list out and keep an eye on any stocks you want to buy so that you can take advantage if there is a big drop in the market.

As for gold, hang on to it. My colleague Merryn Somerset Webb talked about when the end game for gold will arrive on her blog yesterday. Suffice to say that while a resolution to the debt spat might see gold slip from recent highs, we're not at the end point yet.