Always consider hidden risks
SP500 and Higher Real Interest Rates: an Explosive Mix ?
Sep 6 ( From Reuters, Yahoo News, Irish Times, High , BOE )
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The Situation

On June 19, in a statement after a two-day meeting, the Federal Reserve said it will keep buying $85 billion a month in Treasury bonds and mortgage-backed securities until the labor market improves substantially, echoing its statements since last fall.

​​But this time, the Fed invoke the What-If Scenario: at the press conference, Mr. Bernanke said that if the economy unfolds as the Fed expects—and he emphasized the "if"  it would reduce later this year the size of its purchases of Treasury and mortgage-backed bonds.

​​​​​​“Not surprisingly, we try to identify unusual patterns in valuations, such as historically high or low ratios of prices to earnings in equity markets. We use a variety of models and methods; for example, we use empirical models of default risk and risk premiums to analyze credit spreads in corporate bond markets. These assessments are complemented by other information, including measures of volumes, liquidity, and market functioning, as well as intelligence gleaned from market participants and outside analysts.

​​In light of the current low interest rate environment, we are watching particularly closely for instances of "reaching for yield" and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves. ​​“

​​​“The second motivation for more intensive monitoring is the apparent tendency for financial market participants to take greater risks when macro conditions are relatively stable. Indeed, it may be that prolonged economic stability is a double-edged sword. To be sure, a favorable overall environment reduces credit risk and strengthens balance sheets, all else being equal, but it could also reduce the incentives for market participants to take reasonable precautions, which may lead in turn to a buildup of financial vulnerabilities. Probably our best defense against complacency during extended periods of calm is careful monitoring for signs of emerging vulnerabilities and, where appropriate, the development of macroprudential and other policy tools that can be used to address them.​​“

Monitoring the Financial System
​Chairman Ben S. Bernanke
At the 49th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago, Chicago, Illinois
May 10, 2013
Market Reaction to the What-If Scenario a la Bernanke

​​The sell-off in stocks, bonds and commodities that rippled around the globe after Bernanke's remarks looks to some like the dawn of a new period of volatile, disorderly trade - a stark change from the calm that prevailed since the Fed began its most recent bond-buying program last autumn.

Indeed, the bond market is at the epicenter of the financial market earthquake that Bernanke unleashed. Benchmark yields, which Fed easing had driven to record lows, surged to near two-year highs.

To add to the volatility, the Asian Markets were already in a correction phase and was amplified when the PBOC ( The People's Bank of China ) reluctance to inject liquidity into a financial system and create that big liquidity shortage had hit an all time high.

First Warning Sign From Bernanke

​In a speech in Chicago on May 10 2013,, the US Federal Reserve chairman said he was watching for signs that banks were resorting to speculation because of low interest rates, highlighting the danger that easy monetary policy could inflate new bubbles in asset prices.

His comments show how low interest rates have come to dominate global financial markets as waves of monetary easing send investors scurrying around the world for anywhere they can earn a return on their cash. The average yield on lowly rated corporate debt, or junk bonds, this week dipped below 5 per cent to a record low that is less than US treasury bonds yielded in 2007.

​​​ ​Ben Bernanke warned against excessive risk-taking in financial markets then as the dollar was driven up in the latest manifestation of a desperate global hunt for yield.
First Shot Across the Bow

​​​​“I can empathize with investors who are reaching out to high-yield bonds for reasons of income. Not only are Treasury yields low, but we are also seeing yields on dividend-paying stocks fall as well,” Rotblut said. “What has me worried, however, is that some investors are ignoring the risks of higher yields. Getting an extra few percentage points in yield right now may not be enough to offset a large future decline in price.” writes Charles Rotblut, editor at the American Association of Individual Investors (AAII) Journal.

​​The quest for higher yields is going to end badly for some investors. There is new evidence that some investors are ignoring risks in exchange for quenching their thirst for income.

​​The uncertainty the Fed has sowed by telling markets they are on their own means the days of almost uninterrupted gains that have prevailed since late last year are over. And that brings problems of its own for investors and the market.

Real rates are one of the main factor that drives financial markets. In our case, a rising real rates environment in the US is bull
​US Dollar and bear stocks...

Let s just hope that interest rates will not behave as we saw in the scenario of 1994...​​
The SP500 and Real Rates: a Very Bad Mix

​​Most of us think that rates have a direct impact on stocks. But in fact, the reality is that Real Rates have a Tremendous impact on stock valuation as we will show you...

​​US Real Rates - a Definition

​​Real interest rates are simply the nominal headline yields that bond investors earn in “risk-free” US Treasuries less the rate of inflation. Normally real rates are positive, investors earn a nominal return higher than inflation. But sometimes the Fed drives real rates negative, forcing real losses in purchasing power upon bond investors. Inflation erodes their investments faster than nominal yields grow them.

In our case, we took the 30-Year Fixed Rate Mortgage Average in the US minus the Personal Consumption Expenditures Excluding Food and Energy year-over-year....

​​Macro Trading Signal

​Real interest rates are a powerful macro trading indicator, but it is important to realize their signals operate at a secular scale. It is a process that can take years to have a reversal in trend. I think we are at the crossroad. Please take a thorough look at the charts below. They speak by themselves. No need to write a 1 000 words to explain it! LOL!

Observe that each time we had our index of real interest rates over or near the 20 mark, Stocks start to loose ground​​.
Since 1984, it is the ninth times it happens...​
Top Chart
​30-Year Fixed Rate Mortgage Average in the US  year-over-year

Bottom Chart
​​​SP500 Index year-over-year Performance
SP500 and Higher Real Interest Rates: an Explosive Mix ?  $SPY, $SPX, $ES_F, $TLT, $ZN_F, $TBF