Interbank Markets Are Telling Investors To Sell The Rally ... Again

by: Todd Campbell

The biggest question weighing on investors as we move into the final week of the year is how long Europe can be ignored. The S&P 500 has rallied 5% since testing and holding support at 1200 and is now firmly into resistance, an ideal spot for short sellers to lay out positions.

European banks continue to tell equity market investors to stand aside. The ECB overnight deposit facility saw deposits swell to EUR346.9 billion overnight, up 31% from December 21st. A fair amount of the recently ECB auctioned EUR489 billion ended up right back at the ECB instead of in the interbank lending market.

The ECB also reported a second week of anemic sovereign bond buying. The ECB doesn't want to be the only bidder in the room, which is one of the reasons it has been so willing to stuff banks with cheap money. But, rising yields in Italy this week, which put them back to 7%, and continually higher creeping Eastern Europe yields, such as Hungary 10 year's which are back near November highs, suggest banks remain more focused on deleveraging than stepping in to buy bonds.

Who can blame them? Banks know the risks better than we do. And with leverage among some of the biggest European banks north of 40%, they can't be blamed for avoiding debt which could continue to fall and must be marked to market. The rally in bond yields ahead of the three year auction seems to have been driven only by a desire to gather collateral to use in the auction. Now the auction is done and banks don't appear willing to continue buying.

Interbank markets remain frozen. The Libor OIS spread, which measures the amount of money banks demand in interest from one another above Central bank rates, has continued to march higher. At 48 basis points, the spread is just shy of a 2011 high. The TED spread, which measures bank lending rates versus Treasuries, made a new high Friday at 58.08.

One of the most worrisome details of the ECB's three year auction isn't in knowing Italian banks were hungry bidders. Instead, it's in the EUR40 billion worth of newly created bank debt, backed by Italy itself, which got put up for collateral. It's one thing to absorb existing debt. It's another to provide cheap money for newly created high risk debt. In all, Italy's banks tapped the three year facility for EUR110 billion, 23% of the total. It seems Italy wasn't willing to take the risk funding would get any cheaper in the first quarter. Not surprisingly, Italy's on the hook for about EUR115 billion in debt due in Q1.

One of the biggest questions facing investors remains Germany. Germany's GDP growth is stagnating. It's very export reliant, particularly to its EU partners, who it funneled plenty of money to over the past decade. This money had returned to Germany in the form of export demand, offsetting lackluster domestic demand. The absence of such demand next year is likely to weigh on GDP. And, with EUR519 billion in Italy, France and Germany debt due in the first half - there will be a lot of paper looking to find buyers. Germany may be the strongest of a bad hand in Europe, but risks are high. Its yield will trend up in 2012. If it does, it will further pressure the region.

The U.S. economy doesn't operate in a vacuum. Clearly, a slowing in the EU will shave GDP here next year. But for now we're still growing. And that is lending support to equity markets. However, with European banks unwilling to lend to anyone other than the ECB, equity market risk remains too high. As a result, investors should be looking closely at the ECB overnight deposits, Libor OIS and TED spreads for clues. If the markets can move to new highs and measures finally show relief - then equity investors will be rewarded. Until then, raise cash and lay out some short side protection with a stop loss above prior highs.

Disclosure: I am long SDS, QID, UUP.