How to trade a US debt downgrade

Even if Congress reaches a budget deal, S&P might still cut the nation's credit rating. Suggestion: Increase your positions in cash and precious metals.

By TheStreet Staff Jul 28, 2011 1:43PM

By Robert Holmes, TheStreet

 

On March 28, after a week that saw the Dow Jones Industrial Average ($INDU) jump 3%, money manager Jeffrey Sica predicted that the borrowing and spending by the U.S. would prompt a downgrade of U.S. debt. Four months later, it appears that gloomy prediction will come true.

 

Even if a short-term compromise on the debt ceiling is reached, Sica is bracing for a downgrade of U.S. debt by credit ratings agencies by making what some observers have called unpatriotic bets: short positions against U.S. Treasurys and the U.S. dollar, moving to higher levels of cash and buying commodities like oil, silver and gold. Sica is the president and chief investment officer of Sica Wealth Management, a Morristown, N.J., company with about $1 billion in assets under management.

 

Standard & Poor's warned last month that it would downgrade the triple-A rating of U.S. debt if significant progress were not made in dealing with a ballooning deficit. The credit ratings agency said the U.S. would need to cobble together a plan that would lead to $4 trillion in savings, a task that appears impossible amid the partisanship in Congress.

 

Even now, proposed deals by House Speaker John Boehner, R-Ohio, and Senate Majority Leader Harry Reid, D-Nev., promise less than $3 trillion in spending cuts. With a Treasury-imposed deadline of Aug. 2 to raise the debt ceiling, investors have lost faith that Congress can reach a deal that will satisfy S&P analysts. Over the past five trading sessions, the Dow has dropped 3%.

 

"In March, I looked at what a colossal failure our government had been at stimulating the economy, and I knew that there was no way these oppositional views would come together," Sica says. "Based on the divisive views from the two parties in Congress, you knew it was going to become an issue. The political divide was becoming extremely evident back in March. Now here we are at the precipice, and it's gotten even more divisive."

 

Sica, who is also a former managing director for Wells Fargo, argues that the debt ceiling debate is being handled as a political issue when it's really an economic issue.

 

"Politicians on both sides are saying S&P should not involve itself with political issues," Sica says. "That is the most erroneous comment they can make. Politicians themselves made an economic issue into a political issue." The bickering across the aisle in Congress will force the S&P's hand, he says. "There will be a downgrade. There is no doubt about it. There has to be."

 

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For some market observers, it's hard to take a downgrade from credit ratings agencies seriously. After all, they were the same entities that continued to award triple-A ratings to asset classes that imploded in 2008 during the housing crisis. After the debacle with collateralized-debt obligations, or CDOs, S&P and other ratings agencies are stuck between a rock and a hard place.

 

"I would not want to be working for S&P right now and making this decision," Sica says. "Either S&P will step up and do the right thing or they'll lose credibility forever. They'll face tons of criticism from the government, even though the government screwed this up to begin with. This could be S&P's moment to stick to their mandate and show the reason they've existed to begin with."

 

Under the S&P guidelines, the agency must look forward from three months to longer than a year in order to assign a credit rating. While the government could come to a temporary solution to raise the debt ceiling, Sica says that the S&P will be forced to act and protect its damaged credibility if congressional leaders offer no plan to deal with permanent changes to entitlement programs that could lead to severe deficit problems in the future.

 

"They can't embrace quick-fix solutions. Any potential solution would avoid default, but they need to justify the coveted triple-A rating," Sica says. "They need to address the overriding issue. Entitlement programs have been a third rail for both parties in Congress. They won't touch them. If you have any debt and you simply pay interest with no reduction in principle, you do not warrant a triple-A rating. That rating belongs to surplus-oriented entities."

 

Sica doesn't expect a full-blown Armageddon if the U.S. loses its prestigious triple-A rating, but the outcome is certainly not all sunshine and flowers. After a downgrade from the S&P, Sica says pension funds with mandates of triple-A rated holdings will be forced to sell government issues, triggering a surge in yields as prices plummet. Borrowing costs will increase as the biggest holders of debt lose faith in the U.S. government and sell Treasuries.

 

Outside of the bond market, the dollar will decline against the yen, euro and Swiss franc. Money markets will trade below net asset value, Sica predicts, which could prompt nervous selling. Consumer confidence will plunge further as well. The Bloomberg U.S. Consumer Comfort Index fell to a reading of -46.8 last week from a prior reading of -43.3, a sign that consumers are very pessimistic already.

 

Among equities, companies with solid earnings such as Microsoft (MSFT) and Coca-Cola (KO) could see revenue decrease as borrowing costs rise, Sica contends. It will be cats and dogs living together, mass hysteria, to borrow a quote from "Ghostbusters." (Microsoft owns and publishes MSN Money.)

 

Because of his view, Sica is positioning his investors for a downgrade. His strategy is straightforward, as he's increasing his cash levels to over 50%, he's holding about 10% to 15% of his assets in precious metals like gold and silver, and he is buying oil-related assets as he expects oil prices to continue higher. He is a buyer of the iShares Dow Jones U.S. Oil Equipment Index (IEZ) and the iShares Dow Jones U.S. Oil & Gas Exploration Index (IEO).

 

On the other hand, Sica says he has cut his position in equities to under 10%. Most of the stocks his firm owns are related to mining, like Freeport-McMoRan (FCX). "We feel a lot more comfortable with stocks like that because there is not a lot of supply of gold or silver," Sica says. "We've been buying those types of companies."

Gold and silver trades have been extremely profitable lately on rising fear. For example, the SPDR Gold Trust ETF (GLD) has jumped 7.5% in July, and the iShares Silver Trust ETF (SLV) has jumped an impressive 14%.

 

Sica is also making several politically unpopular bets, such as shorting the U.S. Treasury as well as the dollar. That bet is based on the expectation that bond yields will rise and the dollar will depreciate. He is buying exchange-traded funds that are short Treasuries, including the ProShares Short 7-10 Year Treasury ETF (TBX), the ProShares UltraShort 20+ Year Treasury ETF (TBT) and the ProShares UltraShort 3-7 Year Treasury ETF (TBZ), to capitalize on the inevitable rise in interest rates.

 

"I've had people say it's politically incorrect to bet against the U.S. Treasury," Sica says. "People will say that it's unpatriotic. I'm very patriotic in my love for this country and everything about this country. But what has made this country great is our economic responsibility to our taxpayers and citizens. From my core function to manage money professionally, we feel the U.S. Treasury will fall in price and rise in yield. We're using strategies that will profit from that."

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