Debt Deal Almost Done, Now What?

Last night, news emerged out of Washington that a deal had been reached regarding the U.S. deficit and ability to raise the debt ceiling, and the futures surged. This morning, as traders awoke, futures came off their best levels of the session, and traders faded the open, selling the rip. Once the weak ISM report came out, the gains were gone and stocks fell deeply in the red, down more than 1% as of the time of this writing. Adding fuel to the fire was the Congressional Budget Office, or CBO, coming out this morning grading the cuts made to the federal deficit, and it was a pretty weak effort by Washington. Only $2.1 trillion will be cut in the next 10 years, with just $21 billion being cut next year. S&P in recent weeks has said that it needs to see $4 trillion in cuts over 10 years for the U.S. to keep its AAA rating. $2.1 trillion is nowhere close to $4 trillion, but it does appear that the ratings agencies are losing any semblance of credibility with their "downgrade" calls, especially when it comes to wanting a particular number in terms of cuts. The ratings agencies were nowhere close to be found when it came to 2008 and predicting the financial crisis. All of the stuff that was supposedly "AAA" rated was not anywhere close to it, so why should we give them credence for anything they say. Goldman Sachs weighed in this morning on the debt deal, with some comments this morning. "The start of this week will be dominated once again by the US debt ceiling agreement. The President announced last night that a deal had been reached in principle by the leaders of both Chambers. As a result, US futures have traded higher overnight, while the USD has rallied against the CHF and JPY, but weakened notably against the rest of Asia. But the critical question remains whether the votes will be there once all sides consider the proposal. So there could easily be more volatility to come. What is striking, as we discuss below, is that the market has traded the lack of agreement on the debt ceiling so far less on the notion of debt sustainability or credit risk and more as a further risk to the US cyclical picture. The fact that yields have fallen sharply is the clearest indication. Having taken a more upbeat cyclical trading stance a few weeks ago, we were finally stopped out of a short 5-year UST recommendation on Friday after the close below 1.40%, having been stopped out of a long recommendation in our Wavefront Growth basket in US equities a couple of days before." Nancy Pelosi has said that she does not know which will she will vote, which could cause House Democrats to not vote for the deal, but Congressmen Paul Ryan (R-WI) came out just moments ago and said it will pass. There is so much knee jerk reaction to every headline out of Washington now that the only action we see is whipsaw. Eventually, a deal will get done, whether it is before the all important August 2 deadline or not. Chances are, U.S. debt is likely to receive a downgrade from AAA to AA perhaps by Christmas, or even sooner. The mess in Washington has not stopped, and the markets will continue to react in the short term to everything and everything out of Washington. In short, nothing has gotten done and we are nowhere. Welcome to the new America. ACTION ITEMS:

Bullish:
Traders who believe that a deal will get done eventually might want to consider the following trades:

• We could see a rally in equities ars we extremely oversold at this point. Traders should be aware that oversold conditions can remain oversold.

Bearish:
Traders who believe that a debt deal will not happen before the deadline may consider an alternate positions:

• If we default on our debt and the debt rating is cut, there is going to be nothing but chaos on Wednesday at 12:01 a.m. iShares Barclays 20+ Yr Treas.Bond ETF TLT could be a good short, but yields on U.S. debt continue to go lower, as there is nowhere else to go. Perhaps traders could play the other side of the trade by going long TLT and shorting equities, as there is nowhere else for money to go.

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