Analysis: Traders hedge bets as budget talks turn to bluster

House Speaker John Boehner makes a brief statement to the media at the Capitol in Washington December 19, 2012.

Credit: Reuters/Gary Cameron

By Steven C. Johnson, Doris Frankel and Ryan Vlastelica

NEW YORK/CHICAGO | Thu Dec 20, 2012 10:52am EST

NEW YORK/CHICAGO (Reuters) - U.S. markets in the last few weeks have conveyed a strong sense of optimism over Washington's budget battle - perhaps a bit too much.

The benchmark S&P 500 index .SPX recently capped off its best two-day run in a month and the euro reached an 8-1/2-month peak against the dollar, largely on expectations that an agreement to avoid the "fiscal cliff" - $600 billion in automatic spending cuts and tax hikes set for early next year - is nearly at hand.

But at the risk of sounding like Ebenezer Scrooge, some investors fear a sudden run of bad news could snuff out the pre-holiday cheer and send stocks down. As a result, they are wading into the options market to hedge their bets and protect their profits.

"With all the uncertainty, we want exposure to sectors but we don't want to risk as much," said Michael Matousek, senior trader at U.S. Global Investors Inc, which manages about $3 billion. "We want to limit our positions because we don't know what will be impacted and by how much."

Republican Speaker of the House John Boehner, in a brief press conference on Wednesday, dared President Barack Obama to oppose Republican plans to cut taxes for all but those making $1 million or more in annual income.

After his remarks, both the S&P 500 .SPX and the Dow Jones industrials .DJI hit the day's lows.

Boehner's gambit, which followed another press conference where Obama suggested Republicans need to get over reflexive opposition of him, shows the two sides still have work to do to bridge their divide.

"It is very difficult to say if the optimism out there is warranted," said Alec Young, global equity strategist at S&P Equity Research in New York. "We don't know what's going on behind the scenes, and that makes it very difficult to account for all the uncertainty out there."

PLAYING IT SAFE

Some investors have started to limit exposure to stocks that have had a strong runup. A popular strategy is stock replacement, which involves selling shares outright and, instead, buying a call option - a bet the stock will keep rising - on those securities.

This allows investors to take profits and also reduce risk, particularly if budget talks break down and the market sells off. But they retain the option to get in on the gains if things go well by exercising their call, or "buy" options.

"We have seen this strategy in eBay (EBAY.O), Dell (DELL.O), Juniper Networks (JNPR.N), Coca-Cola (KO.N) and Starbucks (SBUX.O), among others," said Phillip Saunders, an equity derivatives strategist at Topeka Capital Markets.

Another approach: covered calls, in which investors hang onto a position while simultaneously selling a call option on it to increase their income. In this case, if the asset falls in value, some of the losses are offset by the premiums collected on the unexercised call option.

It's a strategy that Michael Fredericks, who manages the BlackRock Multi-Asset Income Fund, has employed with high dividend-yielding U.S. stocks, which could suffer if no deal is reached and dividend taxes spike from 15 percent to as high as 40 percent for some earners.

"When you add the value of selling an options contract to the dividend payment some companies distribute, you end up with a really attractive value proposition," Fredericks said.

The benchmark S&P 500 is up nearly 15 percent this year, with three sectors - industrials, financials and consumer discretionary shares hitting 2012 highs. That has increased the desire to hedge. On Wednesday, put options - bets on a market decline - on the S&P were trading more than three times the average volume of the past five trading days.

"What this suggests is that people are buying options in the S&P 500 index in order to protect themselves in case of a selloff into year-end," said J.J. Kinahan, chief derivatives strategist at TD Ameritrade.

TAIL RISK NARROWS

Overall, volatility remains low as stock trading winds down for the year. The CBOE Volatility Index .VIX, Wall Street's "fear gauge," rose to 17.4 on Wednesday, spiking after Boehner's comments but still well below its long-term mean of 20.5.

The market slipped following Boehner's words, with the S&P ending down 0.76 percent, but the overall low volatility suggested investors believe the outlook remains positive.

"I definitely think there is some risk, though," said Douglas DePietro, head of trading at Evercore Partners in New York, adding that some investors were protecting themselves by buying funds that bet on declines in the S&P 500.

Currency investors who fear a plunge over the "fiscal cliff", should consider selling currencies with strong U.S. links such as the Canadian dollar and Mexican peso against the Japanese yen, which usually rises when risk aversion spikes, said Steven Englander, who heads Citigroup's global G10 FX strategy.

He said some investors might be reluctant to hedge their bets now, after having been over-cautious in the past and missing out on the rally.

Unlike in early 2012, investors are no longer singularly focused on protecting against massive risks such as the 2008 market meltdown or the possible demise of the euro.

"Through much of this year, these....outcomes were central scenarios that investors pursued, and that in some cases weakened the returns that they got," Englander said.

But Michael Khouw, head of equity derivatives at CRT Capital Group in Stamford, Connecticut, said thin pre-holiday trade may be suppressing volatility somewhat.

"I don't think that the options markets are overly complacent," he said. "I would have expected option volume to drop off this year and it has not, and this is a reflection of the fact that market participants could expect a sharp move, up or down, in equities."

(Editing by David Gaffen, Tiffany Wu and Leslie Gevirtz)

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"Fiscal cliff" talks turn sour, Obama threatens veto

1 of 2. U.S. President Barack Obama speaks about the fiscal cliff to members of the media in the White House Briefing Room December 19, 2012.

Credit: Reuters/Kevin Lamarque

By Matt Spetalnick and Mark Felsenthal

WASHINGTON | Thu Dec 20, 2012 1:23am EST

WASHINGTON (Reuters) - Talks to avoid a U.S. fiscal crisis stalled on Wednesday as President Barack Obama accused opponents of holding a personal grudge against him while the top Republican negotiator called the president "irrational."

As a year-end deadline nears, Obama and House of Representatives Speaker John Boehner are locked in intense bargaining over a possible deal to avoid the so-called fiscal cliff of harsh tax hikes and automatic spending cuts that could badly damage an already weak economy.

Obama said he was puzzled over what was holding up the talks and told Boehner's Republicans to stop worrying about scoring "a point against the president" or forcing him into concessions "just for the heck of it."

"It is very hard for them to say yes to me," he told a news conference in the White House. "At some point, you know, they've got to take me out of it."

The rise in tensions threatens to unravel significant progress made over the last week.

Boehner and Obama have each offered substantial concessions that have made a deal look within reach. Obama has agreed to cuts in benefits for seniors, while Boehner has conceded to Obama's demand that taxes rise for the richest Americans.

However, the climate of goodwill has evaporated since Republicans announced plans on Tuesday to put an alternative tax plan to a vote in the House this week that would largely disregard the progress made so far in negotiations.

On Wednesday, Obama threatened to veto the Republican measure, known as "Plan B," if Congress approved it.

Boehner's office slammed Obama for opposing their plan, which would raise taxes on households making more than $1 million a year and is a concession from longstanding Republican opposition to increasing any tax rates.

"The White House's opposition to a backup plan ... is growing more bizarre and irrational by the day," Boehner said through his spokesman, Brendan Buck.

Boehner expressed confidence the House would pass the legislation on Thursday. He urged Obama to "get serious" about a balanced deficit reduction plan.

Wall Street is on edge over the fiscal cliff talks although investors still expect a deal. The S&P 500 stock index slipped 0.76 percent on Wednesday.

Business leaders have descended on Washington to lobby for a deal to avoid going over the cliff while putting public finances on a more sustainable path. Without an agreement to narrow deficits over the long run, the United States could eventually lose investors' trust, triggering a debt crisis.

An acrimonious presidential campaign that culminated in Obama's re-election on November 6 has added to the bad blood in Washington between Obama and congressional Republicans.

The two sides also clashed bitterly last year over the government's limit on borrowing - known as the debt ceiling - an episode that nearly led the nation to default on its debt.

On Wednesday, Obama said the fiscal cliff must not get bogged down with negotiations over the debt ceiling, an issue that must be dealt with again early next year.

But Boehner's offer to raise the debt ceiling enough for another year of borrowing is facing opposition from a large group of Republicans, a House Republican aide said.

LITMUS TEST

Any fiscal cliff agreement by Obama and the Republican leadership would need the support of their parties' rank and file in Congress, and Thursday's vote on Plan B will be a test of Boehner's ability to deliver votes on any eventual deal.

Boehner faces opposition from Republican Tea Party conservatives over his concession to raise tax rates. But in a sign some conservatives are coming around to Boehner's position, anti-tax activist Grover Norquist gave his blessing to the bill.

Other conservative groups, including the influential Club for Growth, are urging Republicans to vote against Plan B.

Obama and Boehner appear to have bridged their biggest ideological differences but remain hung up on the mix of tax hikes and spending cuts meant to narrow the budget gap.

"What separates us is probably a few hundred billion dollars," Obama said.

The White House wants taxes to rise on household incomes above $400,000 a year, a concession from Obama's opening proposal for a $250,000 income threshold.

If a deal is not reached soon, some $600 billion in tax hikes and spending cuts are set to begin next month.

Senior administration officials described negotiations as at a standstill and Obama warned he would ask everyone involved in the talks, "what it is that's holding it up?"

Still, the top Republican in the Senate said a resolution to the stalemate could come by the end of the week.

"There's still enough time for us to finish all of our work before this weekend, if we're all willing to stay late and work hard," said Senate Republican leader Mitch McConnell.

Many Democrats dislike the president's offer to reduce benefits to seniors, although some political allies of Obama have given signs they feel they could swallow this concession.

"I don't like these particular changes," said Democratic Representative Chris Van Hollen, a member of the House leadership from Maryland. But he added: "What people are seeing is the president willing to compromise in order to get things done."

(Additional reporting by Roberta Rampton, Thomas Ferraro and Vicki Allen; Kim Dixon and Richard Cowan; Writing by Jason Lange; Editing by Alistair Bell and Eric Beech)

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Republicans put squeeze on Obama in "fiscal cliff" talks

1 of 3. U.S. House Speaker John Boehner (R-OH) speaks at a news conference after a Republican caucus meeting on Capitol Hill in Washington on December 18, 2012.

Credit: Reuters/Joshua Roberts

By Thomas Ferraro and Richard Cowan

WASHINGTON | Wed Dec 19, 2012 1:34am EST

WASHINGTON (Reuters) - Frustrated by their inability to wring more "fiscal cliff" concessions out of President Barack Obama, Republicans in the U.S. House of Representatives announced Tuesday night that they expect to pass their own tax bill as a backup plan to avert the tax hikes and automatic budget cuts set to occur in January.

No one expects the bill, which would extend low tax rates except on income of $1 million and above, to pass the Democratic-controlled Senate. President Barack Obama's latest position puts the threshold for income tax hikes at $400,000.

While the move, called "Plan B" by Republicans, may not prompt Obama to give further ground in his negotiations with House Speaker John Boehner, it could allow Republicans to argue they did what they could to stop tax hikes and the full impact of the "fiscal cliff," which the Congressional Budget Office and economists have said could trigger another recession.

"Why not put on the floor something that's what most Americans think the president is talking about, which is protecting from tax increases everybody but truly millionaires and billionaires?," said Republican Representative Pat Tiberi of Ohio.

When it dies in the Senate, he said, "that's not our problem. We can't be held responsible for what the Senate does."

Polls have consistently suggested that the public is likely to blame Republicans for failure to reach a deal ahead of the December 31 deadline for action.

After important concessions in recent days from both Obama and Boehner, Republicans expressed frustration that the president had not moved further.

The White House seemed unconcerned by the Republican tactic, and stressed Obama's willingness to compromise further.

"The president has demonstrated an obvious willingness to compromise and move more than halfway toward the Republicans," White House spokesman Jay Carney told reporters, adding that Obama is making a "good faith" effort to reach a compromise.

Still, the mood on Capitol Hill was guardedly optimistic.

Global stocks advanced to their highest levels since September. Investors shifted funds to stocks and the euro and pulled away from safe-harbor assets such as bonds, gold and the U.S. dollar.

"They've still got a long way to go, but you can't help but say that the odds are better today than they were on Friday that we'll get some sort of agreement," said Oklahoma Republican Representative Tom Cole.

Hopes of an accord rose Monday night after Obama made a concession with his offer to limit tax increases to incomes exceeding $400,000 per household. That is a higher threshold than the $250,000 that the president had sought earlier.

Boehner, the top Republican in Congress, had earlier conceded on Obama's insistence that tax rates rise on the wealthiest Americans, but the two have been unable to agree on what income levels should be included in that category.

Analysts said Obama and Boehner may strike a compromise at $500,000 or close to that, though time was running short.

One House Republican aide, asked about prospects for "Plan B" on the House floor, said: "It wouldn't be surprising ... if a lot of conservatives balk at something like that." The House's second ranking Republican, Eric Cantor, said he was confident his party members in the House would back the bill.

'WE CAN DO BETTER'

Even as he presented the measure, Boehner said he would continue to negotiate with Obama on a broader agreement.

"Plan B is Plan B for a reason. It's a less-than-ideal outcome. I've always believed we can do better," Boehner said.

The expiration of low tax rates enacted under former President George W. Bush is a key component of the "fiscal cliff" that lawmakers are trying to prevent from taking hold next month, along with deep automatic government spending cuts.

Often challenged by the conservative wing of his caucus, Boehner held Republican lawmakers together in support of his efforts to forge a deal with Obama. The speaker emerged largely unscathed from a potentially tough meeting with his fellow House Republicans on Tuesday morning.

Representative Darrell Issa, a key committee chairman, said his fellow House Republicans "were supportive of the speaker. ... I saw no one there get up and say, 'I can't support the speaker.'"

With opinion polls showing broad support in the United States for raising taxes on the wealthiest Americans and Obama still buoyed by his re-election last month, the Republicans' traditional opposition to tax hikes has waned somewhat.

The Obama-Boehner talks have largely overcome stark ideological differences and are focused increasingly on narrower disagreements over numbers.

COST-OF-LIVING INCREASES

Obama also may face unrest from within his party. Liberal Democrats were likely to oppose a key compromise he has offered to permit shrinking cost-of-living increases for all but the most vulnerable beneficiaries of the Social Security retirement program. His proposal calls for using a different formula, known as "chained Consumer Price Index," to determine the regular cost-of-living increases, essentially reducing benefits.

"I am committed to standing against any benefit cuts to programs Americans rely on, and tying Social Security benefits to chained CPI is a benefit cut," Democratic Representative Keith Ellison said in a statement.

Obama also moved closer to Boehner on the proportion of a 10-year deficit reduction package that should come from increased revenue, as opposed to cuts in government spending. Obama is now willing to accept a revenue figure of $1.2 trillion, down from his previous $1.4 trillion proposal.

Boehner's latest proposal calls for $1 trillion in new tax revenue from higher tax rates and the curbing of some tax deductions taken by high-income Americans.

Missing from Obama's latest offer was any extension of the so-called "payroll tax holiday" that ends on January 1, bringing an immediate tax increase on wage earners.

Possible plans to produce cuts in spending for Medicare and Medicaid, the government health insurance programs for seniors and low-income Americans respectively, remained to be discussed.

Boehner and Obama have made headway on the politically explosive question of the president's ability to avoid constant battles over raising the nation's debt ceiling, which controls the level of borrowing by the government. Boehner is ready to give Obama a year of relative immunity from conservative strife over the debt ceiling, while Obama is pushing for two years.

(Additional reporting by Thomas Ferraro, Rachelle Younglai, David Lawder, Richard Cowan, Matt Spetalnick, Roberta Rampton, Jeff Mason and Fred Barbash; Writing by Kevin Drawbaugh; Editing by Alistair Bell, Will Dunham and Paul Simao)

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