FINANCIAL ICEBERG
Always consider hidden risks
MARKET INSIGHT
The Perfect Financial Storm: A Potential Severe Correction ?
( From FRED, Business Insider,  FX Empire,  )
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In summary, I can say that increase in real rates, underestimation of risk, opacity, interconnection, complencency and leverage, all combined can create again potentially
​the perfect financial storm.

​​
The Situation

It all began a few weeks ago with the fear of "Tapering" in the context of the Federal Reserve.​​ "Tapering" in the context of the Federal Reserve is the process to slow down the pace of the bond purchases (longer-term Treasury securities set at a pace of about $45 billion per month and agency mortgage-backed securities (MBS) set at a pace of about $40 billion per month).

​​Since the publication of the FED minutes​​ on May 22, the market has been interpreting that the FED will start the tapering process as soon as June of this year. Since then, market volatility has increased tremendously in the financial markets; MBS has been sold aggressively, the bond market started to be under pressure and stocks sold off violently.

And the worst fear of the market came on June 19 with Bernanke s press conference:​​

​​"Although the Committee left the pace of purchases unchanged at today's meeting, it has stated that it may vary the pace of purchases as economic conditions evolve. Any such change will reflect the incoming data and their implications for the outlook, as well as the cumulative progress made toward the Committee's objectives since the program began in September.

​​Going forward, the economic outcomes that the Committee sees as most likely involve continuing gains in labor markets, supported by moderate growth that picks up over the next several quarters as the near-term restraint from fiscal policy and other headwinds diminishes. We also see inflation moving back toward our 2 percent objective over time.

​​If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear.

​​In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains, a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program."

​​

Consequences

Macro Trading Signal - Rates

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. And here, we have a very special occurence;
a rising  interest rates ( the tapering effect )​ with falling inflation...

Read also: US Real Rates - a threat to Stocks ?
Current level
​US Treasury Constant Maturity 10 years minus  % ( Blue / Left Scale )
SP500 Index Inverted Quarterly ( Red / Right Scale )​
Rising interest rates are typically a good sign for the economy and stocks, but one of the exceptions is when interest rates rise too quickly.
In these cases, usually stocks do perform very badly.

​​Please take a thorough look at the charts below. They speak by themselves.

As you may observe on the chart below, when we have a quick and huge shift in rates, stocks fall...​​
1994 Scenario

​​But the real fear of the market is a 1994 kind of scenario; a huge spike in rates with stocks tumbling...​​

​ In 1994 the combination of stronger-than-expected payroll, a tighter Fed, a 200bps back-up in yields led to a big pause in the nascent equity bull market and a savage reversal of fortune in leveraged areas of the fixed income markets (e.g. Orange County & Mexico). Investors should therefore be reducing longs positions in illiquid markets like in High Yield and EM debt aggresivvely ...

​​
1994
​US Treasury Constant Maturity 10 years minus % ( Blue / Left Scale )
SP500 Index Inverted Quarterly ( Red / Right Scale )​
Even if the reason are not the same for interest rates spikes ( 1994 was a stronger economy put the Fed to hike short term interest rates and now the tapering effect are creating deleveraging process out of bonds ), the consequences are the same....

So in 1994, ​​between February and May,  US Treasury Constant Maturity 10  years went from 5.8% to 7.4%, a 27.5% rise in yield...
Stocks during that time ( SP500 ), went from ​480 to 445, a 7.3% decline as shown by the chart above...

And from the beginning of May 2013, US Treasury Constant Maturity 10 years went from 1.8% to 2.4%now, a 33.3% rise in yield...
Stocks during that time ( SP500 ), went from ​1582 to 1592 now, a 0.6% rise as shown by the chart above...

On that basis, stocks appear extremely vulnerable because the system is a lot more leverage than in 1994 and the buildup
​of debt is quite huge.​​
Market Funds Selling US Bonds Already

​​The ICI ( Investment Company Institute ) reported huge estimated weekly net cash outflows from bond mutual funds of $13.5 billion during the week of June 12, following a $10.9 billion outflow the prior week as shown by the chart below...
​The biggest outflows of the past 5 years !

Interconnection

US Emerging Markets Bond Funds ETF ( EMB )


​​The surge in yields in the US has roiled also into other foreign credit markets harder because of their illiquidity. And that ETF has lost about 13.0 percent from its latest peak on April 29 as shown by the chart below...
US Treasury Bond Fund ETF ( TLT )

​And  the sell-off in U.S. government debt has been swift and dramatic. The iShares Barclays 20-year-plus exchange-traded fund , one of the most popular bond ETFs, has lost about 12.5 percent from its latest peak on April 29 as shown by the chart below...
US Investment Grade Corporate Bond Fund ETF ( LQD )

​​The surge in yields has roiled other credit markets here and abroad as shown by the US Investment Grade Corporate Bond Fund
​ETF ( LQD ), and has lost about 8.0 percent from its latest peak on April 29 as shown by the chart below...
That  kind of situation can bring back easily the Asian financial crisis of 1997 especially at a time when China experience a huge cash squeeze that is quickening the pace of asset liquidation in Asia...

Read Also: ​​

​​Cracks Appearing on the Great Financial Wall of China - Remember 1997 ?

​Asia s Capital Flows: The Tapering Effect-Remember 1997 ?

​​
Market Funds Selling Emerging Bonds Already

​​​In the week ended June 19, EM funds recorded a massive $2.6 billion in outflows, or 1.0% of assets under management.
That marks an acceleration of outflows from the previous week, when investors redeemed $2.5 billion from EM funds.


Market Funds Selling Emerging Currencies Already

And the repatriation of those bonds and stocks from the Emerging Markets impacted tremendously the Emerging Currencies
​ (iShares Wisdom Dreyfus Emerging Currency Fund ( CEW )) as shown by the chart below...​​

​​
Market Funds Selling Emerging Stocks Already


​​​​​The surge in yields in the Emerging Markets has roiled  Emerging stocks too ( MSCI Emerging Markets iShares (EEM)).
​ And that ETF has lost about ​17.0 percent from April 29 as shown by the chart below...
Leverage

​​NYSE Margin Debt Hit New Record, Surpasses 2007

​​Margin debt—that’s the amount of money borrowed to purchase stocks—on the New York Stock Exchange (NYSE) reached its all-time high in April. Margin debt on the NYSE registered at $384.3 billion as the key stock indices hit new record-highs. (Source: New York Stock Exchange web site, last accessed May 29, 2013.) The highest margin debt ever reached prior to this was in July of 2007, when it stood just above $381.0 billion. At that time, just like today, the key stock indices were near their peaks and “buy now before it’s too late” was the prominent theme of the day
The Perfect Storm - Liquidity Crunch - Leverage - COT - Commodities

​​​SHIBOR Liquidity Crunch

​Banks are hoarding money to meet quarter-end capital requirements at the same time as capital inflows are easing amid a worsening economic outlook and speculation that the Federal Reserve will rein in monetary stimulus. The one month repurchase rate, a gauge of interbank funding availability, has more than doubled in the past month and the China A50 index has lost 9.5% since April 26 as shown by the charts below.
                                  SHIBOR 1 Month                                                              FTSE Xinhua China A50 Index ( FTX )
The level of Debt

As you may observe in the chart below, ​​I put the scale at 100 on December 1997 on each data to be able to evaluate the change
​since the beginning of the financial crisis. It will be a lot easier to visualize the change and growth of debt... And the so obvious is that the level of debt at all sector ​( Corporate, Consumer and especially Federal Governement ) are way higher than at the beginning of the crisis; have we learned something ?
US Nonfinancial Corporate business Total Liabilities ( Blue / Left Scale )
​US Total Consumer Debt Outstanding ( Red / Left Scale )
​US Federal Debt Total Public Debt ( Green / Right Scale ) 
​Scale at 100 on December 1997​​
Market Positionning COT - Still Way Too Long

Small speculators as reported by the ​​Commitment of Traders on SP500 E-minis ,E-Mini NASDAQ and E-Mini Russell 200 are still way too long the equity market ( green line on bottom panel of each chart ) if you check the charts below. That is still a huge risk for the market as they will have to liquidite or face margin calls...
Commodity Prices - CRB Index

​​Commodities, including crude oil and gold dropped  tremendously after the US Federal Reserve hinted  that quantitative easing may be reduced in the future. Even if the Fed improved its projections for the next year’s economic indicators, the market s worst fear of slowing the pace of money into the system combined with the slowing of the Chinese economy are putting pressure on the commodities as shown by the CRB Index below...
Conclusion

The Federal Reserve by mentioning that it is considering the tapering process combined with the slowing of the world economy triggered a sell off in all the major asset classes; be aware that the deleveraging process in the financial assets have begun...

​​For me, all the factors are there for a perfect storm​​: Cash squeeze in Asia ( remember 1997 ? ), Huge Leverage in the market and by all sectors ( Financial Markets, Corporate, Consumers and Governments ) and market positioning way too long are all major risks now...

The other factor is that the sensitivity of interest rates are a lot more now than in 2007 because of that huge leverage.
Financial markets started the correction process, margin calls will do the work until we reach 10/15% minimum from the peak in the SP500​​​.

Have we learned from 1994, 1997 and 2007 ?​​

​​