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While much has been made of the credit freeze faced by European banks, most analysts continue to point to high capital ratios at major U.S. banks as a sign that Wall Street is prepared to weather the European storm. However, the reality of the situation is that the crisis in Europe is already starting to spread across the Atlantic, as Libor has been ticking steadily higher since July. While funding stress in the US has not been widespread enough to damage the titans of Wall Street, the climb in Libor is a worrying signal that the flow of credit is once again beginning to be impeded in the U.S. economy. With virtually no progress having been made in increasing bank transparency, it's little wonder that banks are pulling back on lending during a time of large macroeconomic upheaval and counterparty risk. Nevertheless, the increasing risk aversion in the interbank market means that we once again can see the risk that a solvency crisis in a few European countries might metastasize into a full-blown liquidity crisis like in 2008.

Since July, 3 month USD libor has more than doubled, up from 0.25% to 0.54% today. While the level is still low due to historically low interest rates, the trend has been up almost daily since the European market worries send the market into a tailspin in late summer. Even more ominously, 3 month libor has reached a level not seen since July 2009, when an easing of post-Lehman funding stresses caused rates to move lower. While 3 month libor did briefly jump last summer on Greek default worries to levels close to where we currently stand, the recent rise has already lasted longer and shown no signs of stabilization. Moreover, the TED spread (the spread between 3 month Libor and the 3 month Tbill) has blown out even more dramatically, exceeding last summer's peak by 5 basis points for the highest level since May 2009.

All of these signs point ominously to the fact that the European contagion is slowly creeping outward and beginning to infect other markets. Even as recession worries have waned as a string of strong U.S. economic data has buoyed the mood of forecasters, the credit noose is tightening around the U.S. economy. As Libor is base rate for many mortgages, student loans, auto loans, and corporate financing, the rise in Libor is rapidly transmitted to the broader economy, resulting in a credit squeeze that could easily push the U.S. back into recession if the situation worsens. With corporate profits currently at record highs that look unsustainable in a slowing economy and the major indices once again failing to decisively break through resistance, the market looks set to retest previous lows in the coming months. The divergence between equities and credit markets over the last two months is not going to last forever, and past experience has shown that credit markets usually win in the end.

For long only investors, there is not a lot left to do but move to cash and mark time. Until 3 month Libor shows signs of stabilization, the balance of risk continues to be for a pullback. Meanwhile, for investors looking to play from the short side or hedge, buying puts on the SPY looks enticing as the VIX is hovering around a 3 month low. Though not my favorite trading vehicle, leveraged short ETFs such as the SDS provide a trading vehicle for those not willing or able to use options.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 3 Month USD/Libor At Highest Rate Since July 2009 As Contagion Risk Grows