We have been asked by clients and prospects:
— “How will a US default on its debt affect futures markets?”
So I turned to my colleague, Jonathan Day who has been a senior broker with Cannon Trading since 2003 and is an ex floor broker/ trader for his insights:
The 1 billion (or I guess in this day and age the trillion dollar) question is, what happens if by August 2nd a deal has or has not been agreed on and the ramifications to commodities and futures markets? Based on the past performance of the US government it is likely that in the waning moments, our divided leaders will agree to some sort of deal. If a deal is not reached, does the sun rise the next day?
Let’s start with a deal not being reached and debt ceiling is not raised. There is no way around the fact that the rating agencies will have to down grade US debt. This, in turn, will trigger sell offs in equities, US treasury futures and most commodities. With yields on the rise, a surprising winner in the short term could be Gold and possibly silver, as traders will be looking for a short term haven for cash getting pulled from every other asset class. After the initial shock of the August 2nd deadline deal not being struck, look for the Fed balance sheet to expand tremendously over the next several days to provide cushion for the market. I would look for a rise in yields to continue in US treasuries until a deal is done. Then it could materialize into buying situation for treasury futures as the higher yields will put pressure on equities and Bernanke to take action to try and cap rates. He has already hinted loudly that more quantitative easing is on the table.
Another interesting outcome of a technical default would be the opportunity and first step to create meaningful fiscal policy to getting the US government’s finances in order. These reductions would help strengthen the dollar and fiscal outlook which in turn would help create good standing with our creditors. Benefactors would be the dollar and bonds and the losers would be equities and precious metals.
I am not very optimistic about that outcome as it would take nerves of steel by our leaders. The probable outcome will be last minute deal that kicks the proverbial “can” down the road and accomplishes little in the way of meaningful deficit reduction. This leaves us more or less in the same position we are in right now. In short commodities, bonds, and equities will benefit with a knee jerk reaction and precious metals will take a hit. Once the euphoria of the crisis averted has worn off we would slide right back into the same trap until we need the debt ceiling raised again.
If the deficit reduction is going to be more than 4 ½ trillion, I expect a large rise in the in the bond market. In turn, there will be a large decline in precious metals.
If you are China and hold a tremendous amount of US paper which you can not move with any speed or size for obvious reasons. Would you prefer to wait a week for some coupon payments while US creates meaningful deficit reduction measures? Or take your payments on time with a wet noodle deal that will only weaken the value of your investment over time.
Look for choppy markets over the next 10 trading days and remember Washington has the track record of always “kicking the can down the road” so trade accordingly and good luck.
** The material contained in this letter is of opinion only and does not guarantee any profits. These are risky markets and only risk capital should be used. Past performances are not necessarily indicative of future results.
*** This is not a solicitation of any order to buy or sell, but a current market view provided by Cannon Trading Inc. Any statement of facts herein contained are derived from sources believed to be reliable, but are not guaranteed as to accuracy, nor they purport to be complete. No responsibility is assumed with respect to any such statement or with respect to any expression of opinion herein contained. Readers are urged to exercise their own judgment in trading!