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As lawmakers fiddle, investors primed to profit

By Jennifer Ablan and Matthew Goldstein

NEW YORK (Reuters) - Money managers sitting on piles of cash are sniffing out opportunities to make a killing on the political circus in Washington over raising the nation's debt ceiling.

Just eight days before the critical deadline to raise the debt ceiling before the United States would default on its debt obligations, Republicans and Democrats were still locked in a stalemate on Monday. The prospect of politicians failing to reach a deal before the August 2 deadline is finally rattling some investors' nerves, judging by Monday's declines in global equity markets.

Cooler minds still expect a resolution--even if it's a deal struck at one minute before the deadline for raising the debt ceiling. But in the intervening days, savvy money manager say there is a real opportunity to take advantage of expected volatility in stocks, bonds and currencies -- assuming that sanity ultimately will prevail in Washington.

"If the market takes a sharp drop this week, we will probably accelerate and go back into the market and start to re-risk our portfolios," said Keith Wirtz, the chief investment officer at Fifth Third Asset Management, with $18 billion in assets. His firm is sitting on 10 percent cash, up from 2 percent in April.

Bill Gross, the co-chief investment officer of Pacific Investment Management Co., the nation's largest bond investment firm with $1.2 trillion in assets, said managers there are actively discussing how to deploy excess cash.

Perversely, some big money investors are quietly rooting for a market rout because that may be what is needed to bring politicians to their senses -- and create a chance to buy heavily battered stocks in the process. Already, some managers have made a small fortune on panicky moves sparked by ever-changing news headlines related to the debt talks.

Tad Rivelle, chief investment officer for fixed income at TCW, which manages $120 billion in assets, said the firm was purchasing 10-year Treasury notes a few weeks ago when their yield was around 3.20 percent. Now, he said, "This might be a good time to sell."

U.S. Treasuries sold off heavily in late June as the focus turned toward the gridlock in the U.S. government as well as the end of the Federal Reserve's second round of quantitative easing -- a $600 billion program of bond purchases that had injected a huge amount of liquidity into the market. Since then, the yield on the 10-year U.S. Treasury note, which moves inversely to its price, is down 20 basis points at 3.00 percent.

Still, money managers like Rivelle acknowledge there's a chance that lawmakers won't get their act together and the United States actually defaults. If that were to happen, the results would be hard to predict but likely reminiscent of the reverberations during the collapse of Lehman Brothers in 2008.

"I don't think there is any plausible way that investors can position themselves for the tail risk of political risk management and outright debt default," said Rivelle.

Yet even as big money traders are seeing profits from the political squabbling in Washington, others are beginning to worry about what they see as a more likely scenario: a downgrade of the nation's prized AAA credit rating.

The growing consensus on Wall Street is that while a deal to raise the debt ceiling will be reached, any deal will not reduce the deficit enough to prevent a credit downgrade by the major credit rating agencies. A modest downgrade of U.S. debt would not be as nearly catastrophic as a default, but it is prompting some investors to worry about the stability of some money market funds.

The fear a downgrade of U.S. debt could result in some money market funds heavily invested in Treasuries to "break the buck" -- a decline in net asset value below a dollar. This last happened to the Reserve Primary Fund in September 2008 after Lehman Brothers collapsed.

DOWNGRADE PROTECTION

The financial crisis, however, created a measure originally aimed at protecting companies from community bank failures that may be getting new life as a way to guard against a potential debt downgrade.

One trader said a few money managers are considering moving some cash into non-interest-bearing checking accounts on which the Federal Deposit Insurance Corp. is providing unlimited insurance guarantees. The unlimited guarantee runs through December 2012.

Some suggest these accounts could prove useful to money managers and even corporations that are keeping large amounts of cash in low-interest-bearing money market funds and don't want to get caught off guard by a downgrade.

Even so, the high of uncertainty about the current state of affairs, noted one West Coast fund manager, means no one really knows the extent of damage to the financial system in the event of a default or a downgrade.

"We are living through the biggest monetary and fiscal science experiment in history," said the manager. "Anyone expressing 100 percent confidence in the outcome is either a liar or a fool."

(Reporting by Jennifer Ablan and Matthew Goldstein; Editing by Leslie Adler)

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