What Happens in Europe Doesn’t Stay in Europe

The ECB ended its bond purchase program in January but European bank loans and deposits rose to new all-time highs.

All the growth came from the increase in mortgages outstanding, in what has become a long running saga.

Virtually free mortgage credit goes a long way to promoting a housing bubble.

The ECB is promoting one with negative interest rates.

While I was in France for 3 months this winter, I saw mortgages advertised at a 0.5% interest rate.

So, naturally, that begets a central bank subsidized bubble.

The ECB’s monthly data on the European banking system shows that without that bubble, the European banking system would be shrinking.

The ECB has created an illusion from which it cannot easily walk away.

Here’s why that’s critical to us as investors in the US markets.

Europe isn’t Las Vegas – What Happens There Hits Home Too

Allowing the European banking system to shrink would obviously be a catastrophe for Europe.

But ultimately, all financial roads lead to Wall Street.

The big investment banks and trading firms known as Primary Dealers all play in one worldwide money pool.

When the ECB prints money, it’s not just available to Europe, it is also instantly available to Wall Street. When the ECB doesn’t print, there’s little extra cash available for Europe to send packing to the U.S.

Therefore, what happens in Europe doesn’t stay in Europe.

That’s why it’s important to keep track of the performance of the European banking system.

The U.S. Treasury’s International Capital report showed that Europeans held $7.9 trillion of U.S. stocks and bonds in November.

Their monthly net transactions typically range from zero to $60 billion per month, but there are also months where there are net sales of $60 billion per month.

In 7 of the 9 months most recently reported through December, Europe was a net seller of U.S. securities.

We knew during that time that the ECB was cutting back on QE, and that there would be less money for Wall Street. That showed up in the markets in a big way in the fourth quarter.

So it behooves us to pay attention to the health of the European banking system.

If bank deposits are growing in Europe, some of that growth results in investment flows to the U.S. If European deposits are stagnant or declining, it’s bad news for the U.S. as well as Europe.

The challenge is that we don’t have direct, current data on these flows. The TIC reports have a severe lag.

The most recent data is for December, and we’ve had a huge stock market rally since then.

More current data on the European banking system comes from the ECB. We now have banking data from January.

From that, and our knowledge of ECB policy, we can cobble together an outlook for European capital flows to the U.S.

This analysis is an important cog in the big picture of liquidity analysis that can give us a heads up on potential impacts for the U.S.

The ECB’s Current Plans Won’t Help the U.S.

The ECB has now ended its bond purchase program (aka QE).

However, it will continue to replace maturing bonds in its portfolio.

That will keep the balance sheet stable for a while, but the balance sheet would begin to shrink as the due date approaches for banks to repay the special targeted lending program loans (TLTRO) they got from the ECB.

A shrinking ECB balance sheet in combination with a shrinking Fed balance sheet would starve markets of the cash they need to absorb over $100 billion per month in new U.S. Treasury supply on average.

In March, that figure is $246 billion, a crushing burden for the markets with no help from the Fed or the ECB.

Shrinkage of the ECB’s balance sheet would start to happen this year if the ECB sticks with current policy.

The deadline for the repayment of the first tranche of TLTRO loans is March 2020.

Early prepayments are likely to start this year because negative interest rates act as a disincentive to hold deposits.

The banks can eliminate that cost by using deposits to pay down loans. The European banking system would shrink.

They may also sell some U.S. Treasury securities.

We saw that process in 2013 when the first LTRO loans started to mature and had to be repaid. U.S. Treasury prices plunged during that time.

But now the ECB is quaking in its boots, thanks to the worldwide stock market selloff in Q4 of 2018 and weakening European economic data.

It has floated trial balloons about a new special lending program to start later this year.

The last thing the ECB wants is to allow its loan programs to be paid down, pulling cash out of the banking system, like what the Fed has done under its balance sheet “normalization” program.

Now that the big central banks have seen a hint of the result of these programs, they are backpedaling fast.

But if the ECB merely keeps its balance sheet stable in size, it will not help the U.S. markets.

At least one of the big central banks needs to have a QE program creating enough cash to absorb the massive flow of new U.S. Treasury supply coming to market every month.

If both the ECB and Fed decide to merely stand pat, U.S. stock and bond markets should remain under pressure, with intermittent declines, because of the massive pounding from the never ending flow of new Treasury supply hitting the market month after month.

But it would be worse if one or both allow their balance sheets to shrink.

So far, the Fed seems destined to allow its balance sheet to continue shrinking until year end, according to the latest media trial balloons.

The new uncertainty about the direction of central bank policy means that technical analysis will remain pre-eminent for intermediate term market timing.

But the trends we see in Europe are no basis for expecting a revival of long term demand for U.S. securities.

I’d continue to be content holding and rolling short term Treasury bills until the Fed and ECB start printing again.

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