How to Spot the Foreign Market "Contagion" About to Go Viral

Europe has always played a huge role in the U.S. markets. The U.S. Treasury reported that European investors and central banks held $1.6 trillion of U.S. Treasury securities in June. More importantly, they had purchased $114 billion of that over the past year, including $32 billion from April to June.

And although there's no breakdown of U.S. stock and corporate bond holdings by country, Treasury holdings are about one third of total foreign securities holdings. Assuming that ratio applies to European holders, then they hold a total of roughly $4.8 trillion in U.S. assets and added nearly $100 billion of that over the April-June period.

There's little doubt that this has helped drive the stock market blowoff.

That cash flows into the U.S. markets. When European investors buy Treasuries, most of those purchases are from U.S. Primary Dealers, even if they are not direct purchases of U.S. stocks. The dealers use some of the cash they get in those sales to Europeans to buy stocks. When European investors, or U.S. corporations in Europe, buy U.S. assets, that adds liquidity to the U.S. system and fuel for the inflation of the U.S. stock market bubble.

So I have always found it important to track the monthly data on the European banking system for you. Its growth, or lack thereof, matters to the U.S. market - whether that growth is intrinsic, or smoke and mirrors.

To find out whether European banking is really obscuring the truth about the U.S. market, we must take a deep dive into the data. That's what I'm doing here for you today. Unfortunately, what we find might not lead to the most heartwarming reassurance about the U.S. stock market's current trajectory.

That's because a looming, so far unseen contagion is currently buried in the heap of it.

The Contagion Is Hiding Amid Misleading European Lending

Lo and behold, smoke and mirrors continue to drive lending and deposit growth in the European banking system. The inflation of a European housing bubble, with increases in mortgage balances outstanding, plays a huge role.

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Then there's interbank fun and games with the European Central Bank's Targeted Long-Term Lending Operation (TLTRO). These have been the sources of all of the apparent growth in the assets of European banks.

In reality, while loans and deposits have grown, total assets have not grown at all. Apparent asset growth in some national banking systems in Europe has been offset by the ongoing collapses or lack of growth in others.

Meanwhile, the forces driving the apparent growth of loans and deposits are unsustainable. The ECB is in the process of cutting its quantitative easing (QE) to zero. Under QE, the ECB buys bonds to add to its balance sheet. That forces cash into the European banking system. But when QE goes to zero in December, liquidity will shrink and so will the flow of European money into U.S. markets.

European banks have already taken baby steps toward repaying the ECB's massive phony loan program, the TLTRO. The TLTRO loans were supposed to stimulate lending. But the only lending they stimulated was interbank lending designed to take advantage of the interest bonus the ECB would pay based on the increase in loans.

We're Running out of Time to Prepare Before Trouble Spreads...

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This program begins to expire in stages in March 2020. That's when the banks are required to pay off the first series of TLTROs. That deadline is a long way off, and by then market conditions could be so bad that the ECB will reverse policy.

In the meantime, however, the banks have begun paying down those loans. The loan paydowns should accelerate as the deadline approaches. Such paydowns will mean that the ECB's balance sheet will shrink, and there will be less cash in the European system available to flow to Wall Street to inflate U.S. stock prices.

European banks will need to liquidate assets to pay down those TLTRO loans. Many of those assets, including Treasuries and stocks, are held in the United States. Liquidating those assets will pressure U.S. asset prices and remove cash from the U.S. system. We saw that process in 2013 when European banks paid down the original ECB long-term lending program, the LTRO. U.S. Treasury note and bond prices collapsed and yields soared as a result.

Back then, the Fed had the market's back. Now the Fed is in the process of draining money from the banking system and the markets, under its balance sheet normalization program. Because U.S. assets are the most liquid assets in European portfolios, meaning that they are the easiest to sell to raise cash, make no mistake - they will be sold! That European selling pressure, added to the Fed's draining operations, will make the environment even tougher for the U.S. market.

Once This Country Breaks Down, the Contagion Is Inevitable

At the same time, except for Portugal and bogus circular bailouts in Italy between the government and the banks, Europe's weak sister banking systems are showing no sign of recovery.

The elephant in the room is Spain. Its system is loaded down with loans to Turkey. The Spanish banking system looks ready to resume its collapse, from which it never recovered in the first place.

If deposits in Spain break down, contagion is likely. The U.S. markets will be a liquidity sink as margin calls go out around the world.

I'll be keeping my eye on Spain, and I will notify you whenever things get worse.

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The post How to Spot the Foreign Market "Contagion" About To Go Viral appeared first on Lee Adler's Sure Money.

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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