Investors lay last-minute hedges as U.S. default clock ticks
LONDON, Oct 16 (Reuters) - Investors who believe Washington would strike an 11th hour deal on the budget and avoid default may be forced to think again and scramble for trades to hedge their U.S. sovereign debt and dollar exposure.
The United States is hours away from exhausting its borrowing capacity, though lawmakers were said to be close to agreement. Failure to reach a deal by the Oct. 17 deadline would pave the way for a default that could cause havoc in global financial markets.
Over the past few weeks investors have generally remained sanguine, taking their cues from the last such cliff-hanger in August 2011, when equities fell and bond yields rose only to reverse sharply as lawmakers reached a deal.
But less than 24 hours before the deadline, investors are more inclined to recall the 2008 collapse of Lehman Brothers investment bank, protect their portfolios and try to profit from the risks.
"The fact that Lehman was allowed to go bankrupt underscores that the track record of much more frequent last-minute solutions provides only limited comfort," said Valentijn van Nieuwenhuijzen, head of multi-asset strategy at ING Investment Management.
His suggestions included options to sell shares, credit default swaps and seeking safety in German government bonds.
"Given how the market is trading it's not expensive to hedge. We would recommend a combination of puts on equities, sovereign CDS and German Bunds. If there were an accident, Bunds are the obvious candidate for save-haven flows."
Germany ranks 6th in BlackRock's Sovereign Risk Index, ahead of the United States in 15th place. The top three safest countries in the index are Norway, Singapore and Switzerland.
Rising political tensions have been pushing its U.S. "Willingness to Pay" index lower throughout 2013.
Japanese government bonds, lower rated than those of Germany, may also benefit as Japanese investors repatriate their overseas holdings, nearly half of which are in U.S. Treasuries.
Japanese investors already sold a record amount of foreign bonds on a net basis in the week to Oct. 5, offloading nearly $23 billion worth - a move that may accelerate in coming days.
So far, stress is most evident in short-term funding markets. The cost of insuring against a U.S. default over a one-year period hit a fresh two-year high of 75 basis points, compared with just 6 bps at the beginning of September.
Treasury bills maturing at end-October, most exposed to the possibility of missed payments, saw yields shoot up to 0.67 percent, having traded near zero in September.
The overnight rate to obtain cash in the short-term repo market hit a nine-month high of 0.35 percent, compared with 0.03 percent in August.
Some market participants said that while uncertainty persists, investors may prefer to swap Treasury securities for triple-A rated debt issued by federal agencies such as Fannie Mae and Freddie Mac.
One-year debt issued by Freddie Mac yields 0.13 percent , less than one-year Treasuries. Reflecting the near-term default risk, the Treasury yield curve is inverted, unlike the Freddie Mac and Fannie Mae curves.
Citigroup's chief financial officer, John Gerspach, said on Wednesday the bank no longer holds Treasuries maturing on Oct. 31 or before.
The Volatility Index, known as Wall Street's "fear gauge" - has yet to see sharp gains, reflecting relative market calm. The index stands at 18.6 percent, less than half levels seen after the collapse of Lehman Brothers.
"If you're going to play it through options, the best way to do it would be to go long volatility going into this crisis. We've been overweight VIX, and we've generated alpha (return) with that," said Ramin Nakisa, strategist at UBS.
European stocks have outperformed Wall Street since the debt impasse caused a partial government shutdown. Since Oct 1, the EuroSTOXX 50 index of euro zone blue chips has risen 2.1 percent , compared with 0.2 percent on S&P 500 index.
On the options market, demand for bets on equity markets rising through call options on the EuroSTOXX 50 outstripped bets on the market falling in October and November on Tuesday, when a deal appeared to be in reach.
Wednesday has seen renewed interest in protection against the market falling before the October options expiry on Friday.
For November, though, positioning remains upbeat, according to data from Eurex exchange.
In the currency options market, there is growing demand from investors to bet on the Swiss franc to appreciate.
One-month dollar/Swiss implied volatility has risen to 8.3 percent from around 7.3 percent in mid-September.
One-month dollar/Swiss risk reversals, a measure of relative demand for options on a currency rising or falling, show fewer bets on dollar gains.
Stephen Gallo, European head of FX Strategy at BMO Financial Group, said in a note he still favoured owning Swiss francs.
"This is a classic 'too big to fail' dilemma: a U.S. default is just too big of a dilemma for policy makers to not avoid - but it's still a dilemma which may not be avoided, and people should not proceed 'un-hedged'."
(Additional reporting by Toni Vorobyova, Alistair Smout and Jessica Mortimer, editing by Nigel Stephenson and David Stamp)