ETFs To Watch As Debt Ceiling Deadline Nears

by on July 28, 2011 | ETFs Mentioned:

Most investors probably never expected that it would never come to this. With only days remaining until the day the government coffers supposedly go dry, a deal to avoid a default remains elusive (one would suspect the August 2 date is at least 72 hours or so in advance of a hard deadline). The back and forth negotiations in an increasingly tense debt ceiling standoff have captured the attention of Wall Street and investors around the globe, and the negotiations in Washington figure to be a primary driver of global financial markets in coming days.

The impact from the debt ceiling drama will likely be felt far and wide; the manner in which this issue is ultimately resolved should have an impact not only on U.S. debt, but on both domestic and international stock markets and a number of different asset classes as well. Though a compromise with strong bipartisan backing appears increasingly unlikely, such a scenario would likely give a huge boost to both Treasuries and stocks that have slid in recent days. Failure to reach a compromise could be disastrous not only for debt of the U.S. government that goes technically into default, but for all assets denominated in the U.S. dollar. And perhaps the most likely scenario, a temporary solution that satisfies neither political party, would cast uncertainty over the entire situation and perhaps set up markets for a repeat of these negotiations a bit down the road [see ETFs To Watch If Meredith Whitney Is Right].

The fast approaching debt ceiling has already rippled throughout global financial markets; below we profile funds that could see additional volatility in both directions as August 2nd approaches [sign up for the free ETFdb newsletter]:

Government Bonds

The asset class most directly impacted by the debt ceiling issue includes those found in the Government Bonds ETFdb Category. Though most investors expect that Washington will ultimately make Treasury investors whole regardless of the debt ceiling resolution, missed interest payments could spark a mass exodus from U.S. debt. If this safe haven falls out of favor, ETFs offering exposure to international Treasuries–such as those in the International Government Bonds ETFdb Category–could see a surge in interest.

Products that may be particularly intriguing include the PowerShares DB German Bund Futures ETN (BUNL) and Japanese Government Bond Futures ETN (JGBL). Germany is one of the few bright spots in Europe, remaining on relatively solid fiscal footing despite the debt woes of its neighbors. And Japanese debt has maintained its safe haven appeal despite the huge debt burden, offering low yields but general stability during turbulent times [see also China Bond ETF Race Heats Up].

Volatility ETPs

Exchange-traded products offering exposure to volatility have become increasingly popular as short-term trading tools, and the components of the Volatility ETFdb Category should see plenty of activity in coming days. Though the VIX has spiked sharply higher in recent days, the market for futures contracts had recently become backwardated–an unusual development for an asset class that is generally in a state of steep contango.

Because the VIX measures the market’s expectations for short-term volatility in U.S. equity markets, developments that cause greater anxiety and uncertainty among investors can give a boost to products that consist of futures linked to the “fear index.” In other words, extension of debt ceiling talks to the last minute could give a boost to products such as the iPath S&P 500 VIX Short Term Futures ETN (VXX), and leveraged VIX ETPs such as the VelocityShares Daily 2x VIX Short Term ETN (TVIX) could see some big swings as well (TVIX gained close to 10% in Wednesday’s session). On the other hand, a resolution that the market deems to effectively address debt concerns could take the air out of the widely followed volatility index; that would be a positive development for the Daily Inverse VIX ETN (XIV) that has been hammered in recent sessions by the spike in investor anxiety [see also ETF Insider: Bullish On Equities].

Gold ETFs

The slump in stocks in recent sessions has, not surprisingly, coincided with a further run-up in the price of gold. The precious metal has defied any notions of a bubble, rising to new record highs thanks to the safe haven appeal of hard currency as the dollar comes under pressure. As evidenced by the recent strong performances, gold often thrives on turmoil in equity markets. If stocks continue to struggle and the debt ceiling comes closer without either side budging, the flight to safer pastures could accelerate–and gold ETFs could be an attractive destination.

There is no shortage of ETPs offering exposure to gold through both physically-backed and futures-based strategies. The most popular is of course the Gold SPDR (GLD), but other bullion-backed options include the cost-efficient IAU (just 0.25% in annual expenses) and two funds from ETF Securities, AGOL and SGOL, that hold gold bars stored in Singapore and Switzerland, respectively.

Short Dollar ETFs

As the debt ceiling draws closer, pressure on the U.S. dollar continues to build. A default would likely accelerate the depreciation of the greenback–at least in the short term–as demand for dollar-denominated assets would drop and confidence in the long-term outlook of the currency would be dealt a stiff blow. Investors looking to bet on the performance of specific currencies relative to the U.S. dollar have no shortage of options; the Currency ETFdb Category includes options for exposure to everything from the Aussie dollar (FXA) to the South African rand (SZR).

There are also a handful of funds that take a more broad-based approach, essentially betting on the performance of a basket of currencies relative to the U.S. dollar:

  • PowerShares DB US Dollar Index Bearish (UDN): This ETF offers exposure to a basket of developed market currencies, with the heaviest allocations going to the euro. Other components include the Canadian dollar, British pound, and Swiss franc. UDN’s hefty allocation to the euro (it makes up more than half of the exposure) should certainly be considered; that currency isn’t exactly on stable footing either now [see also Inflation ETF Special: 25 ETF Ideas To Fight Rising Prices].
  • WisdomTree Dreyfus Emerging Currency Fund (CEW): This ETF offers exposure to emerging market money market funds, meaning that it is positioned to appreciate if currencies of countries such as Mexico, Brazil, China, Turkey, and India gain in value relative to the U.S. dollar. CEW has performed quite well over the last couple of weeks, thriving on the sudden decline in interest for the dollar.
  • WisdomTree Dreyfus Commodity Currency Fund (CCX): This ETF offers exposure to a basket of currencies that includes both developed and emerging markets. Included are the major commodity producing countries such as Australia, Brazil, Canada, Chile, Norway, and Russia [see Getting Creative With Currency ETFs]

Disclosure: Photos courtesy of Ari Levinson. Long XIV at time of writing.