The stock market has moved up over the past month, in line with seasonal expectations. However, one glaring signal continues to flash warning, and that's the interbank lending market.
The Libor OIS spread has increased from 32 bps a month ago to 37 basis points. And, the TED spread, above 45, is similarly high.
The EU bank solution has done little to ease funding risk at emerging eastern European countries. Hungarian 10 year yields spiked, reaching 8.64% amid a series of failed short-term liquidity offerings.
This makes Hungarian yields the highest since spring 2009. The Eastern bloc countries are significantly reliant on EU bank financing, and bank balance sheet deleveraging poses significant risk to their economies. So far, investor's don’t believe the EU's steps will support emerging market neighbors, and are voting with their feet. Until yields begin to retreat, investor's should expect the contagion to spread across weaker economies.
But, risk remains for developed nation debt too. EU measures have offered little help on yields. Italian 10 year yields remain above the ECB's comfort level, back over 7% today, despite significant ECB bond buying last week. Banks continue to unload sovereign exposure with the sovereigns the only remaining buyer.
France's 10-year bond yields are similarly rising, despite moves by French banks to reduce their holdings. France's 10-year yield has moved above resistance at 3.5%, which will likely spark additional selling and drive yields to 4% or higher. This will weigh further on French banks, forcing them to further unwind exposure.
Rising European bank deposits at the ECB is additional evidence of interbank illiquidity. Tuesday, EU banks parked 144.7 billion Euros overnight, up from 122.7 billion the prior night. Emergency lending is also increasing, rising to 2 billion Euros from 1.8 billion Euros the prior day.
While the U.S. exposure to Italy is fairly tame, rising rates in France pose a bigger risk. American bank exposure to Germany and France is estimated at as high as $1.2 trillion. And, U.S. money markets remain key sources of short term French bank funding. Any move from the U.S. markets to curb exposure to France could ripple European markets further.
Which suggests the bottom may not come until the strongest player in the EU is threatened. If this is the case, risk may not peak until Germany's debt spikes. If we do get to a point where French yields toe Germany's higher, Russia could find itself pressured, as Russia holds the third highest foreign currency reserves in the world, over half of which are Euros.
Russia's saving grace remains high oil prices, which have helped the country grow 4.1% this year. But, clearly slowing economies in Europe, which rely heavily on Russian commodities, pose risk to Russia given they account for some 40% of Russia's budget revenue. Russian Ural crude prices have dropped in each of the past two quarters, and industrial production, while still a strong 3.9% in September, has been slowing.
So, while equity markets have moved higher this past month, the credit markets are still flashing caution. For investors, booking gains from recent moves makes sense. After all, the markets tendency to punish greed remains in tact. For those investing overseas, the risk is much higher, particularly given short selling bloodlust.