Trading the Politics of the Debt Ceiling Debate

Mon, Apr 11, 2011 | Jared Woodard

Economy, Politics

I had a few quotes in a recent Reuters article on how to trade a government shutdown – the gist is that, while the shutdown news cycle hadn’t uniquely generated any trade opportunities, an actual shutdown was likely to do so. Of course, an agreement was reached late on Friday sufficient to avoid a shutdown, but last week’s confrontation was just a dress rehearsal anyway – the real drama will occur when the debt-ceiling limits are reached in May.

The politics of the situation present some interesting clues about how things might proceed. Grant the truism that one’s personal politics are of no value when it comes to market-timing or trading; I’m not opining about what should be done here, just about what is likely to happen given the recent behavior of the agents involved.

One interpretation of the game Boehner played last week was that he wanted to look as tough as possible to appease Tea Party zealots and social conservatives without demanding so much that he would give Democrats the ability to step away entirely and paint him as unreasonable. To the extent that Democrats made their first bid by meeting Republicans halfway on spending cuts – instead of, say, threatening to increase spending on programs to bolster aggregate demand – the outcome was always a foregone conclusion, and the news cycle last week was mostly fluff and entertainment. Democrats made Boehner’s job about as easy as it could have been, and they couldn’t really have done otherwise, since the Obama administration has refused to even try to lay the conceptual groundwork for notions like the equivalence of tax increases and spending cuts.

The political dynamic is not likely to shift in the coming weeks, so we will probably be treated to another round of intense theater, in which every participant knows that some basically meaningless changes will be negotiated in the final hour. As I noted in my 2011 preview at Expiring Monthly, the Treasury department has a number of tricks at its disposal to ensure that the U.S. doesn’t actually default on any obligations if the Republicans overplay their hand in May – but Geithner has recently stated that those techniques might actually only extend operations for a few weeks. How do we know that Republicans won’t morph the brinksmanship game into a situation involving outright default? Because the resulting financial disaster would hurt the constituents they care the most about: when major voices within Goldman Sachs and JPMorgan warn of catastrophe, that’s reason enough to be confident that political epiphenomena will not be permitted to get out of control.

In the interim, market overreactions are opportunities for selling option premium. If the posturing is sufficiently intense as to spook market participants, we could see some volatility in the interest rate complex, equity markets, or both. As I mentioned to Reuters, I’d rather be a net seller of volatility in such a situation in whichever asset class sees the biggest reaction in volatility terms. That’s the easy trade. My second idea is to get long volatility in some small size in the short term, on the speculation that worried investors might drive implied volatility higher into early May. At-the-money SPX put options for May expiration are priced currently at about 16% annualized implied volatility, which is about as cheap as they’ve been so far this year.

2 Comments For This Post

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  2. isomorphismes Says:

    The half-floor in BJM was hilarious. Nice reference.

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More


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