There's a European Housing Bubble Threatening to Burn Down U.S. Stocks

I spent several years of my career in real estate, so I've seen a bubble or two. I've watched them inflate, I've stepped out of the way, and I've watched them explode into carnage.

It's never pretty.

Right now, with so much attention on global growth, tariffs, tax reform, and the stock market, no one is really paying attention to a bubble - a dangerous one - forming up right now in Europe.

Why care about Europe?

Well, Europe matters to us - a lot. It matters because a steady flow of buy orders from European dealers, banks, and investors is required to keep U.S. stocks and bonds inflated. U.S. markets would collapse without European buying.

I'm going to show you some charts in a minute - some of the scariest charts I've seen since 2008, really.

And then, of course, I'm going to tell you exactly what kind of cash position you need to have to get through what I think is coming around the corner...

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This Comes at the Worst Possible Time

Since 2013, the population of the European Union has grown by about 2%. That's a growth rate of roughly 0.4% per year. Over that span, consumer prices in Europe have inflated by a total of 3.4%, an average of less than 0.7% per year. Meanwhile, European home prices have risen by 16%.

When house prices inflate eight times faster than population growth and nearly five times faster than consumer price inflation, that's a bubble.

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Europe House Price Index

And we know what drives it - central bank policy that keeps mortgage rates at abnormally low levels, along with a policy that penalizes depositors for holding deposits - negative interest rates. These policies have succeeded in stimulating housing bubbles but have failed to trigger broad economic growth.

The upshot? The ECB's objective of stimulating credit growth, and thereby economic growth, can never be met, because banks and other large entities pay down loans to get rid of the cost of holding deposits. There's just not enough profit opportunity in the real economy for them to take out more loans on balance.

That's why business credit growth in Europe has been, well, stone dead since the ECB instituted the negative interest rate policy (NIRP) and QE in September 2014.

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Loans to Nonfinancial Corporations

Meanwhile, household debt in Europe has soared since the start of QE-NIRP.

Household debt to banks had been growing at an accelerating rate, with the rise becoming parabolic in 2017. Household loans are now growing at a 3.4% annual rate. That's down a tick from 3.5% in December, but still up from 2.0% a year ago.

The fact that consumers are adding to debt while the business is shedding it? Not a good sign.

European Bank Loans to Households

In fact, I think it's a sign of that housing bubble. Mortgage lending rose €170 billion (4.2%) in the past 12 months, despite the first slight downtick in a year in January. That annual increase accounted for 90% of the rise in consumer loans. The increase in mortgages was also 68% higher than the annual increase in January 2017.  Mortgage borrowing has been accelerating along with European home prices in the last year.

Mortgages Outstanding to Households

The mortgage bubble has once again created a situation of immense fragility at the worst possible time. Housing prices are inflated, and borrowers are stretched.

Now the ECB is cutting back QE. In January, it reduced its purchase rate from €60 billion per month to €30 billion.

But issuers, particularly European governments, and not to mention the U.S. government, certainly aren't cutting back issuance. They're adding to the supply of securities that dealers, banks, and investors must absorb. And European banks are big buyers not only of their local sovereign debt, but they are also big buyers of U.S. Treasuries. They now have less money available to absorb the flow of new supply.

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The supply of sovereign debt is ballooning, and the money to purchase it is shrinking. Not only is the ECB buying less, but the Fed is actually pulling money out of the world financial system and markets. It has set a schedule of draining funds from the system that will increase from $20 billon per month now to $50 billion per month in October.

These forces are set in stone by central bankers determined to stick with them until, in Janet Yellen's words, "a material adverse event." Nobody knows what that is, but my guess is that it won't just be a 20% decline in stock prices.

I think that it will take a real financial crisis to get them to reverse course.

Meanwhile, the ECB keeps floating the lie that the European recovery is strong. It's cover for it eventually ending its QE program, possibly this fall, based on trial balloons floated by ECB proxies in the European pundit class.

In any event, the first step in course reversal won't be to print money to buy bonds. It will be to lower nominal interest rates, which will be an "Animal House"-style "really useless and futile gesture" for stopping asset deflation.

Money printing caused the inflation of the asset bubble, and stopping money printing will cause its deflation.

Given these forces, such a crisis is inevitable. It's just a question of time.

And we have a very good idea about that...

Here's When the Bubble Bursts (and Torches Your Money)

As ECB policy and the European housing bubble promote ever greater financial fragility, another disaster looms as a direct result of ECB policy.

The ECB has been promoting a program called Targeted Long-Term Refinancing Operations (TLTRO), which started in 2016.

The essence of the program is that the ECB will pay an interest bonus to banks who take these loans from the ECB and then make business loans above a certain benchmark.

This is free money for the banks.

The ECB is telling the banks, "Hey, we'll pay you to take this money if you lend it out." The problem is, as illustrated above, is that there is no business loan demand.

But as we all know, bankers are clever little scoundrels. They figured out that they can earn that bonus by simply lending the money to each other.

What did they do? Well, they took down about half a trillion in TLTRO money and simply lent it back and forth to each other.

I believe that January spike is another instance of that. There's no other explanation for it.

Interbank Loans

So interbank lending exploded higher to a new high in January. It broke out above the 2008 peak.

Remember what happened in 2008?

The annual growth rate of interbank loans is now a scalding 15.6%. Without these interbank games, total loan growth in the European banking system would have been negative over the past year. Interbank loans rose by - excuse me while I rub my eyes in disbelief - €921 billion in the 12 months ended January. Other types of loans barely grew at all or declined.

In March, European banks will be permitted to start paying off their TLTRO borrowings. Let's listen for a giant sucking sound as banks rush to do that. They will use deposits created when they took the funds to repay the loans. This money, this liquidity, this grease that turns the wheels of markets, will thereby disappear.

Here's the part where it comes home to roost over on our side of the Atlantic.

When that money was created, Europe's banks used some of it to purchase U.S. Treasuries. As deposits grew, U.S. Treasury prices rose, causing yields to fall.

European Bank Deposits-and 10 Year US Treasuries

Some of that liquidity flowing into the US was then directed toward purchasing stocks.

European Bank Deposits and US Stock Prices

European banks will almost certainly liquidate those positions in U.S. Treasuries to pay down the TLTROs.

That's what they did when they were able to start paying down the ECB's original long-term refinancing (LTRO) programs in 2012 and 2013.

European banks had used the LTROs issued in 2011 to buy Treasuries, driving U.S. yields to their July 2012 lows. As soon as the banks were permitted to start paying down those loans, they did. To do so, they sold their U.S. Treasury holdings.

That selling helped drive the yield on the 10-year Treasury from 1.5% to 3% from mid-2012 through the end of 2013.

I have felt, and I believe that we'll soon know for certain, that that was the end of the secular bull market in bonds.

Now, as the European banks get ready to pay off their TLTRO loans, the 10-year U.S. Treasury yield stands at roughly 2.85%. We're likely to see that yield rocket as European banks sell their Treasury holdings to pay off loans from the ECB - loans that they don't want and don't need.

Keep in mind that these sales will come in an environment of very heavy new supply being issued by the U.S. Treasury.

It will not be pretty.

That earsplitting sucking sound you'll hear will be a result of three forces.

  • The European banks will be liquidating Treasuries and extinguishing money...
  • ...at the same time as the U.S. Treasury is sucking up all available liquidity from a pool that is simultaneously being drained by the Fed.
  • Other governments will be doing the exact same thing at the exact same time.

Chances are, the Europeans won't be the only ones selling.

As bond prices go down that drain and yields soar, U.S. stock prices will be pulled down in the vortex. The process of money destruction will be self-reinforcing, causing liquidation of all inflated assets. The liquidation of stocks and bonds to pay off margin debt will in turn destroy money.

At some point, the central banks will be forced to print a lot of money in an attempt to reverse that vicious cycle. But that point is a long way off.  Before the central banks respond, there must first be significant pain, that "material adverse event" that Yellen talked about.

So here's the takeaway:

I think it's a very smart idea to view all U.S. stock market rallies as opportunities to sell and move toward a goal of a 60% to 70% cash position, more or less, depending on your circumstances.

I think I'd modify that old Wall Street chestnut to say "Sell by May and get away." If you're in cash, you'll have plenty of buying opportunities down the road.

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About the Author

Financial Analyst, 50-year charting expert, finance + real estate pro, and market analyst; published and edited the Wall Street Examiner since 2000.

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