Simit Patel

In the United States, state and local governments across the country are experiencing similar debt and budget deficits that the individuals, organizations, and federal government are facing.

In the grand scheme of things, I think we will see a significant amount of risk being transferred to the federal government; in other words, I expect the federal government to "bailout" individuals, organizations, and state and local governments. I view this as one of the major economic shifts going on that the market has not fully priced in yet.

So what's the trade?

If we expect risk to be transferred from municipal bonds to Treasury bonds, we can look to buy MUB -- an ETF corresponding to the S&P National Municipal Bond Index -- while also buying TBT, an ETF inversely correlated to 20+ year Treasury bonds.

Timing is always the issue, of course. One indicator we may find to lead the way would be CXA, an ETF tracking municipal bonds in California. As one of the largest economies within the United States, it can be seen as an indication of where the country is headed. Here are some key insights:

• Goldman has been selling California bonds.
• Economist Mike Shedlock has been tracking the implosion of California -- see his previous coverage from a month ago.
• Welfare checks will be suspended effective February 1.

Let's look at the chart.


The purple and yellow candles are CXA; the red and green are MUB, while TLT is blue and gray. If a sizable bailout does occur and the market has not priced this in, it would be a transfer of risk from the states to the federal government, and thus from CXA and MUB to TLT. We would then expect to see the prices converge. If California is a leading indicator, we may expect to see CXA pave the way.

Other Considerations

There is a question of the legality of the federal government assuming responsibility for the state governments. Thus far the Federal Reserve's bailouts have not been questioned, and thus a precedence of sorts has been set. States have resisted Federal mandates before, so the issue of states rights vs. federal rights may arise again, and may impact CXA, MUB, and TBT as well as other ETFs and investment opportunities.

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