Foreign Banks Have a Greater Impact on This Bull Market Than You May Think

The Fed and the U.S. Treasury are the 800-pound gorillas of the U.S. stock and bond markets. Their actions have largely determined the direction of the markets for the past 15 years.

That's why I developed the LAMPP indicator to track their combined impact and why it has worked so well. I expect it to continue to do so far into the future. It behooves us to pay attention to its message from week to week.

At times when the LAMPP is yellow, some of the dozens of other market liquidity indicators that I track may help us to understand whether to stop or go.

When the Fed is not controlling the market, something else is - and it's probably not what you're being told.

Here's how to understand the impact of foreign banks and what it means for you...

"Proceed with Caution"

There are times though, like recent months, when the Fed is less active and its actions more or less offset the Treasury's actions. This leads to more neutral readings on the LAMPP.

That's when we put up the yellow light, the caution signal. That signal says to proceed with caution, or stop until the light turns green again.

If you like to drive fast, then you're probably one to take your chances and run the yellow. That's fine if that's your style and if it's appropriate for your investment needs or goals. If you are more risk averse, you're probably someone who will stop or at least slow down well before you get into the intersection.

There are a host of indicators that could turn the LAMPP yellow, and they are all relevant.

I track those indicators in the background and report to you when they become significant to the market's direction. I don't want to take our focus off the LAMPP. It's the key. But I do want to acknowledge that there are always other things going on that we shouldn't ignore, especially when the LAMPP is yellow.

Right now, there's a force that is enhancing the bullish side of the LAMPP. It may explain why, with the LAMPP so close to neutral, the U.S. stock market remains so bullish. That indicator measures the amount of U.S. Treasury and Agency securities held by foreign central banks (FCBs). The Fed reports that data every week.

When FCB holdings are increasing, it indicates that FCBs are buying more Treasuries. That's bullish because the FCBs pay for those purchases with cash that goes into the account of the seller, usually a U.S. primary dealer.

Conversely, when FCB holdings are declining, it is bearish because the FCBs are withdrawing funds from the U.S. markets - putting the Treasuries back into the United States and taking the cash to Europe.

So let's have a look at what the data is showing this week...

Finding the Impact

The FCBs have recently been buying U.S. paper at a spectacular rate! This represents a massive influx of dollars into U.S. markets.

Last week, their buying continued at a slower rate than the breakneck pace reached in July. The numbers remain on the plus side on a four-week net basis while the 13-week average has set a record high!

FCB total holdings have risen to near the highs set in 2013 and 2015. They have been surging since bottoming on Nov. 2, the week before the U.S. election. Stocks have rallied strongly in lockstep with this surge, and bonds have also seen a modest recovery.

Here's what appears to be happening. Our review of European banking data suggested that Europeans are selling their U.S. dollar investments and repatriating the cash. When they sell, they are paid in dollars. To repatriate them to Europe and deposit their cash in the bank accounts in Europe, they must buy euros with the dollars. Their selling would normally pressure prices lower.

But for every action there is an equal but opposite reaction. It may not always show up in the same place. It's a matter of finding it and the impact.

In this case, it appears that the European Central bank is recycling the dollars raised when Europeans sell their U.S. investments. The ECB is sending those dollars right back to the United States, offsetting the losses that would otherwise accrue and then some.

The dollars pile up as foreign reserves at the ECB, which then buys Treasuries, which show up in the Fed's custodial holdings. We can measure that.

The ECB buys those Treasuries mostly from primary dealers. It pays for those purchases with the dollars that flowed into Europe when Europeans sold their U.S. assets. The dealers then use that cash to buy both stocks and bonds. Stocks have rallied more than bonds because there's little new supply of stocks to absorb the dealer buying. Meanwhile, Treasury supply has been increasing at its usual pace. So Treasury prices don't rally as much as stocks.

As always, the dealers decide where to send their cash, and in this environment they find it easier to mark up stocks than bonds. That's normal.

Now that we have all this information, what do we do with it?

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The rallies should continue for as long as this recycling of foreign money continues in the absence of Fed action to drain cash from the system. Once the Fed starts draining, probably in October, the markets will become more balanced. The trading range that results should become market tops as the Fed increases its withdrawals of cash from the system over the next year.

We will stay focused on the LAMPP to turn red and tell us that it's time to be out of the U.S. market, or even short. But in the background it will also pay to keep an eye on the trend of FCB holdings. If the buying continues, it could soften the decline that is sure to come when the LAMPP turns red.

However, if the FCB line turns down again, showing that the FCBs have returned to the sell side, it will only exacerbate any red light signal from the LAMPP. Things could get worse - much worse. In that case we'll want to aggressively look for and place shorts on U.S. stocks and bonds and also look for short-term opportunities in put options.

We're not there yet, but be ready!

Don't let complacency about this bull market be your worst enemy.

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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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