On the Verge of a Global Market TsunamiCME: Chinese Yuan (CNH) Euro FX (6E), Micro S&P (MES), Micro Nasdaq (MNQ)
The US government is within ten days of defaulting on its debts. If this unprecedented catastrophe were to happen, what could it trigger?
Risky assets, from stock, bonds, FX, to commodities, will go through a violent period of reset and repricing. Weaker economies could be hit hard if the crisis prompts a flight of financial assets out of the country.
Gold could reach a new record as the primary safe haven asset. Bitcoin and other crypto currencies could also be a winner. US dollar and Treasury bonds, which lies at the core of this market turmoil, could actually gain from it. Past crises show that investors could pick them as the “least bad” option in a flight to safety.
US Government Financials in a Glance
The federal government is in very bad shape, financially. Data released by the Treasury Department shows that:
• The total national debt through May 18th is $31.46 trillion;
• In 2022, US collected $4.90 trillion in revenue and spent $6.27 trillion, contributing to a budget deficit of $1.42 trillion;
• In fiscal year 2023 to date, we have $2.69 trillion in revenue and $3.61 in spending, and already created a budget deficit of nearly $1 trillion;
• Interest rate on national debt has been creeping up since the Fed rate hikes, and reached 1.89% by December 2022;
• Treasury operating bank account has a cash balance of $316 billion.
The low cash balance is shocking. At a burn rate of $523 billion a month, it could only support government spending for 18 days if no new revenue comes in. It is not enough for 6 months of interest payments on debt, left alone paying down the debt.
Where We Are at the Debt Ceiling Negotiation
On May 15th, in a letter addressed to House Speaker Kevin McCarthy, Treasury Secretary Janet Yellen warned of the looming catastrophe:
“We still estimate that Treasury will likely no longer be able to satisfy all of the government’s obligations if Congress has not acted to raise or suspend the debt limit by early June, and potentially as early as June 1.”
The GOP controlled Congress passed a responsible debt limit increase bill last month, but it was rejected by the White House due to its budget constraint requirements.
The two sides are sitting down at the negotiating table last week. But the talks are not going smoothly. House Speaker McCarthy complained about the lack of sincerity from the President who takes overseas trip at the blink of government bankruptcy.
It is still possible to reach a last-minute deal, but a default is no longer unthinkable.
Event-Driven Trading Strategies
In the past, I set up event-driven strategies with Game Theory and Binomial Tree. I think it is useful to discuss two of them before introducing the current strategy.
During the US-China trade conflict in 2019, I used COMEX Gold Options to replicate the risks that global markets would be up against with. “When Trump tweets, Limit Up.” “When Xi calls, Limit Down.” The former shows the tariff fight to intensify, the risk goes up, and so is gold price. The latter indicates that the two sides would engage in negotiation, the risk to deescalate, and gold price will go down.
In the midst of the Russia-Ukraine conflict, I picked CBOT Wheat to replicate the risks to global food supply. The two countries collectively account for 28% of global wheat export.
To predict the probability of conflict outcomes is difficult but unnecessary. Long Strangle options strategy would buy out-of-the-money call and put options simultaneously. It would make money if wheat price had a big move, either up or down.
At the time, $12-strike call was priced three times higher than $9-strike put. The conflict dragged on, but Turkey brokered a deal to allow Ukraine to ship grain cargoes through the Russia-control Black Sea. Wheat futures fell 28% and the Put value went up 1749%.
The links to the above two trade ideas are available at the end of this writing.
Opportunities amid Catastrophes
Taking a one-step binomial tree, the early June debt limit deadline could be expressed in two outcomes: Deal, or No Deal.
In the first outcome, a deal to raise debt limit is reached. Investors are relieved and risky assets shall go up in general. In this case, there are no low-hanging fruits to pick.
I am more interested in the second outcome. The talk breaks down. Financial markets freeze up. Panic selling would push good assets into oversold bargain prices.
Here is my thinking:
Would the US government turn into a deadbeat if no deal is reached? Take a look at the annual federal budget showdown. Talk broke down triggered government shutdown. Millions were furloughed and bills were not paid on time. But when the resolution is reached, the federal workers got called back, and the pass-due bills would all be paid.
Since January, the Treasury Department has been operating in a crisis mood. Legal obligations are still paid on time, while other lower priority spending get pushed back. A No-Deal scenario would result in more payment delay and some furlough.
My conviction is that a “US Default” would be a technical one, and all the government obligations would be satisfied eventually. There are many means to ensure this outcome. In my April 17th writing, I explained that the top 1% of income earners paid 42% of all federal income taxes. Raising tax to the riches would anger 1% of voters but may gain support from the remaining 99%. This is an easy political decision.
Ultimately, all US debts are based on US dollar. We have the money printing machine ready, and it only needs authorization to turn on. A US default would be a good reason.
If a US default occurs, I expect an emergency solution to be reached within days. In addition, the Fed would definitely stop raising rates in its June 14th meeting.
When to Start Bargain Hunting
On the day of US default and a week after, market chaos would present many buying opportunities. What considered a bargain?
For major stock indexes, a one-day drop of 5% or a one-week drop of 10%. CME Micro S&P 500 futures (MES), Micro Nasdaq 100 Futures (MNQ), Micro DJIX Futures (MYM) and Micro Russell 2000 Futures (Y2K) are all good choices.
For individual stocks, the threshold goes up to 10% a day and 20% a week. We all have our favorite stocks on our wish list and were previously turned away by their lofty prices. A big crisis could turn them into bargains, with limited negative impact over time.
For foreign exchange, I would focus on CME Euro FX (6E), British Pound (6B), Japanese Yen (6J) and Chinese RMB (CNH) futures. I think the Dollar could take an immediate beating whenever the news of default hits the wire. However, as soon as a resolution is reached, full faith and credit of the Green Back would be restored. This may give us a few days of opportunity window for bargain trading.
The minimum tick in FX quote is a “pip”, which is the fourth digit after the decimal point. The daily range of price move for the above-mentioned currency pairs is between 30 to 80 pips. My threshold for bargain is a 200-pip daily move and 500-pip weekly move.
Let's take a look at the CNH exchange rate. It experienced four distinguish trends recently:
• Stable rate: Stayed in a tight range of 6.3-6.5 yuan per dollar before March 2022;
• Fast depreciation: Strict Zero-Covid policy pushed the yuan down to 7.3;
• Fast rebound: Reopening in October ignited hope of economic expansion, and the yuan quickly bounded back to 6.67 in two months;
• Fast depreciation: The “Wondering Balloon” incident abruptly stopped the yuan’s rise. Disappointing recovery data sent the RMB into falling again. June futures quotes 7.0325 in the morning of May 22nd.
I think that the Chinese government would like to see the yuan weakened to aid its export. The down trend could continue, and the yuan may retouch 7.3.
If the US dollar fell against the yuan by 500 pips, for example, from 7.0325 to 6.9825, it would be a good point to establish a long position, in my opinion.
Each CNH contract has a notional value of $100,000. When the exchange rate moves 1 pip, a futures position would gain or lose 10 yuan. CME requires initial margin of $21,100 per contract.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
