Yield Curve on CDS Flips - An Opportunity in ETFs? (UUP, UDN, FXF, TIP, STPZ)

As the debate continues over raising the US debt ceiling, market reaction has been reasonably muted, most likely because in the entire history of the US no such occasion has ever before arisen. And it seems that every day brings a new development.

Today’s comes from Bloomberg, which reports that credit default swaps (CDS) on one-year US Treasuries now cost more than CDS on five-year bonds. This is the first time this has ever happened. It indicates that note holders believe that an agreement on a new debt ceiling will not be agreed and that the US will default on its debt. If that happens, swaps contracts will have to be paid. A ratings downgrade of US debt will surely follow.

While all this is uncharted territory, this chain of events could provide an opportunity for investors in certain kinds of ETFs, while making others less attractive. We’ve looked at several, including the PowerShares DB US Dollar Index Bullish (NYSE: UUP), the PowerShares US Dollar Index Bearish (NYSE: UDN), the CurrencyShares Swiss Franc Trust (NYSE: FXF), the iShares Barclays TIPS Bond (NYSE: TIP), and the PIMCO 1-5 Year US TIPS Index ETF (NYSE: STPZ).

The PowerShares DB US Dollar Index Bullish (NYSE: UUP) is a bet on a rising value of the US dollar against a basket of six other currencies. As might be expected, shares in the fund are down more than -12% for the past 12 months, with most of that loss coming since the beginning of the year. The fund’s assets total $1.1 billion, and if the US defaults on its debt this ETF could take a serious beating.

The PowerShares US Dollar Index Bearish (NYSE: UDN), in contrast, is a bet against a strong US dollar. Its returns are virtually the exact opposite of UUP, with a gain of more than 12% in the past 12 months as the dollar has dropped in value. Shares are trading near their 52-week high of $29.33, set in late April.

The the CurrencyShares Swiss Franc Trust (NYSE: FXF) tracks the strength of the Swiss franc against the US dollar, and shares in the fund have gained more than 30% in the past 12 months. Shares posted a new 52-week high yesterday of $123.60. Along with the US dollar, the Swiss franc has been considered a safe-haven for currency traders. If the US does fail to raise its debt ceiling, the Swiss franc may be the only safe haven left.

The iShares Barclays TIPS Bond (NYSE: TIP) boasts assets of around $21.2 billion in US Treasury Inflation-Protected Securities (TIPS). TIPS and this fund are intended to protect investors against inflation as measured by the Consumer Price Index. Shares in the fund have gained more than 6% in the past 12 months, easily besting the rise in the CPI. When inflation is low, as it is now, TIPS are cheap and if the US debt ceiling is not raised, inflation hawks will take flight again and demand for TIPS is likely to take off as well. Shares posted a new 52-week high yesterday at $112.60, and are now trading at $112.35.

The PIMCO 1-5 Year US TIPS Index ETF (NYSE: STPZ) also posted a new 52-week high yesterday, at $54.29. Like TIP, this fund invests in TIPS, but does not include the longer maturity bonds. In the past 12 months shares have gained about 4.3%. Where TIP offers longer-term inflation protection, STPZ offers inflation coverage out to around four years. Again, if the US debt ceiling is not raised, the dollar will fall, releasing new concerns about inflation.

Absent any encouraging signs from Washington, it would not be unlikely to see new highs daily on these ETFs that are betting against the dollar and the US Treasury. How long those gains will continue is really anybody’s guess.

Paul Ausick