Equity Market Still Isn't Worth The Risk

by: Todd Campbell

The interbank funding market is keeping me focused on short positions rather than bargain hunting in the S&P 500 (NYSEARCA:SPY) or NASDAQ (NASDAQ:QQQ). They've yet to confirm the worst is behind equity markets, and that suggests risk remains too high to step into Monday's sell-off.

The Libor OIS spread continues to tell investors banks are scared of each other. The spread has increased to 39 basis points, which is the highest since the recession. And some bids are exceeding 40 basis points, which tells us some banks are even more frightened than others.

The TED spread, similarly, is hitting new highs. It's just shy of 50, which is again the highest reading since the recession.

Overnight deposits stashed by European banks at the ECB also reflect the interbank lending strain. Sunday night, some 236.78 billion Euros were parked at the ECB, nearly 100 billion more Euros than this time last week.

The risk is also reflected in the sovereign debt yields, which remain too high - despite ECB bond buying intervention. Such buying has brought Italy's 10 year yield back below 7%. But for how long can the ECB remain the only buyer in the room? France's 10 year yields similarly retreated back below 3.50%, however, the move above this level last week suggests it's more likely they head back to 4% than continue lower to 3%.

And that means contagion risk remains, particularly for Eastern bloc emerging Europe countries heavily reliant on western Europe funding. As banks continue to try and rein in exposure to sovereign risk, deleveraging will be a cornerstone to survival.

This means you should keep a close eye on Russia too. They backed away from the debt markets last month after a failed auction. But they won't stay away forever. And if European GDP suffers on austerity, demand for Ural's oil is likely to wane and pressure prices, which could significantly impact the country's revenue stream. It's also important to remember Russia, which holds the third highest foreign currency reserves, shifted holdings to Euros from dollars around the same time Gisele was demanding payment in the currency.

Of course, this also suggests that oil itself poses risk. The commodity has hung tough, despite volatility, over the past few months. The WTI ETF (NYSEARCA:USO) remains close to where it traded back in May. But it has also just retreated from testing critical 200dma resistance. Any perception of growth aftershocks should take the commodity lower.

Regardless, credit markets continue to tell investors to be cautious, hedged or net short. Until the Libor OIS spread and TED spreads break their upturn and suggest banks aren't worried about counterparty risk, position yourself for the worst case. After all, sometimes you have to play defense to win in the markets.

Disclosure: I am long SDS, QID, UUP.