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How to Profit from U.S., Europe Debt Crises

Stocks in this article: MCO NBG AIB EWP EWI TYNS TYBS

While traditional retail investors lack access to many of the sophisticated tools, such as currency leverage and CDSs, which hedge funds can utilize to profit from crises, they should be equally aware of the opportunity and risk pervasive in markets. A ramp-up of the crisis in Europe could catalyze another stage of gridlock in markets. Emerging markets, including Brazil and China, are heavily dependent on European end-markets for their sales. Although emerging markets are continuing to decouple from the developed world, they are still more reliant on exports than they are on internal consumption, presenting both risk and safety.

On the one hand, resource-rich and debt-light China has a vested interest in maintaining stability in financial markets and assisting Western nations in their resumption of growth. On the other hand, should the eurozone crisis spread to the U.S., for example, whose national debt has doubled since the recession, instability could cause a massive sell-off in both debt and equity markets. Negotiations to extend our national debt ceiling before a looming August deadline are slow and contentious. Republicans want guaranteed spending cuts and entitlement reductions in exchange for their votes, but are fighting to avoid any tax hikes. Democrats want a revenue bump.

If the U.S. were unable to boost the ceiling hike by Aug. 2, it would result in technical default. With QE2, or the Federal Reserve's quantitative easing, also ending, it's no wonder that investors have exhibited a manic tendency in recent weeks. Several bullish researchers, including fixed-income analyst Jeffrey Rosenberg at Bank of America (BAC), have expressed the view that technical default or missing one or several coupon payments would be an immaterial event. That view is purely speculative and JPMorgan (JPM) has issued a contrary stance, warning that such a move in, by financial definition, risk-free instruments would roil markets and may catalyze another crisis.

A last minute compromise is almost certain. But, should Republicans opt for obstinacy, technical default is possible. As the debt situation has reached a tipping point, Democrats, who control the White House and Senate, have the most to lose in the event of a stalemate. Thus, it may benefit Republicans, though would punish the country, if technical default were to occur because it would be cited as leadership failure ahead of the upcoming presidential election.

One way to insure against a technical default would be by shorting Treasuries. Several ETFs offer short Treasury exposure and several offer exposure with leverage. Direxion now sells two unlevered short Treasury funds: the Daily 7-10 Year Treasury Bear (TYNS) and the Daily 20-Year Plus Treasury Bear (TYBS - Get Report). These funds offer inverse exposure to Treasuries.

-- Written by Jake Lynch in Boston.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.
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