April 7, 2011 / 8:52 PM / in 7 years

US Government Shutdown: How investors might play it

* A looming shutdown presents option-selling opportunities

* Prolonged delay in economic data would stir uncertainty

* Potential bond market trigger, but past shows otherwise

* For long-term investors there’s little cause for concern

By Herbert Lash and Doris Frankel

NEW YORK/CHICAGO, April 7 (Reuters) - There may be some quick profits to be made if the United States goverment shuts down.

Rather than running for the hills in panic, investors may want to take some money off the table now and simultaneously set up some options positions to profit from a recovery once the crisis is over.

If Democratic and Republican congressional leaders fail to reach a budget deal for the rest of the current fiscal year by midnight Friday, the government will have to stop operating, apart from vital services such as defense and law enforcement.

A response on Monday might be selling pressure in U.S. stocks and the U.S. dollar on concern that the shutdown could be prolonged and hurt the U.S. economy, which is still in the early stages of a recovery from the financial crisis.

But the longer the shutdown the more likely lawmakers could face a political backlash from voters -- which means that they should feel pressure to quickly return to the table and reach a deal.

A prolonged delay in U.S. economic data, which will not be published in the event of a shutdown, could create anxiety as well. If investors don’t have a clear understanding on the state of the economy, they could sell U.S. assets. For details see: [ID:nN07146516]

“I would be inclined to be a net seller of volatility in interest rate products,” said Jared Woodard, principal of research and trading firm Condor Options in New York.

A sell-off in Treasury bond futures in recent days has helped increase implied volatility, while the expected magnitude of any Treasury bond futures movement creates some option-selling opportunities, he said.

If implied volatility rises further, Woodard might sell short-term options on U.S. Treasury bond futures, and hedge that position by buying options at the same strike price but with an expiration date further out, he said.

An investor might buy a straddle in SPDR S&P 500 exchange-traded funds, a strategy that is often used to measure an expected move of a security or index in either direction ahead of a risk event, Steve Place, a founder of options analytics firm investingwithoptions.com in Mobile, Alabama.

A stradle combines a call and a put with the same strike price and expiration date, giving the buyer the right to both sell or buy the underlying asset at a set price.

Congress on Thursday neared a budget deal to avert a potential shutdown but disputes over abortion and environmental issues posed hurdles to an agreement before the deadline on Friday at midnight. [ID:nN07296632]

Shutdowns in 1995 and 1996 suggested a slight drop in quarterly growth of 0.09 to 0.17 percentage points, while a stop now could hinder the initial reliability of upcoming data, Nomura Securities said.

A shutdown is an “event” for the market as it gets many people stirred up and upset, said Axel Merk, president and chief investment officer of Merk Mutual Funds, in Palo Alto, California.

Bond markets are likely to stay calm, he said.

Some U.S. investors are adopting “quick trades” as many believe any shutdown would be short-lived.

Investors are positioning for a so-called “bear” steepening of the yield curve, when long-term rates rise faster than short-term rates, said Bret Barker, a portfolio manager at TCW in Los Angeles, who warned the trade might not last long.

“As soon as they pass the budget, we all should be going back to where we were,” he said. “The 2 year is a little safer since it is a short maturity and has less risk, but longer dates, say 10 year and out, might be under selling pressure.”

When the government shut down in 1995 for 21 days the bond market rallied in anticipation of greater fiscal discipline.

U.S. financial markets have barely flinched since a showdown over government funding began to catch headlines.

“This is a perception game and may generate a sell-off in U.S. equities. If there is a shutdown and it spooks markets, then I want to take a position in which ever asset class gets hits the most,” Woodard said.

“So if the pop in implied volatility is greater in U.S. equities reflected by the CBOE Volatility Index, than it is in the interest rate complex, I would rather be an outright seller of short-term VIX futures.”

Those with a longer view of the market and fundamentals, the shutdown is more of a nuisance, not an opportunity.

Shutdowns in the past have been of limited duration, making their impact on both the economy and markets modest and transitory, said David Joy, chief market strategist at Columbia Management, which oversees about $347 billion in assets.

“We have made no changes to our asset allocation specifically in response to the possibility of a shutdown, but are mindful of the potential drag on economic activity should it extend beyond our expectation.” (Additional reporting by Jennifer Ablan in New York) (Reporting by Herbert Lash)

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