Stability Primer: Keep An Eye On the TED Spread

Includes: AIG, BSC, FMCC, FNMA
by: The Simplified Investor

Last week, things looked bleak for equity investors.  As the Dow Jones and S&P 500 slid to historic lows, and the TED spread soared to an historic high (more on that below), it looked to many like the thing to do was pull out of stocks entirely, and enter safer assets like gold, T-bills, and steady bank savings accounts.  But on Monday, the market bounced, led by the news that the U.S. government will invest up to $250 billion to shore up the U.S. banking system in a plan similar to measures taken by several European powers, including Germany and the U.K.

Does this mean the crisis is over, and stocks will recover the trillions of dollars in market cap they lost over the past two weeks?  Unlikely.  Events of the past several months have shown that each time the market rebounds, a fresh bit of disheartening news about one macroeconomic indicator or another causes a sharp decline.  

Just recently, this happened after the government intervened with Bear Stearns (NYSE:BSC)…and again when it saved Fannie Mae (FNM) and Freddie Mac (FRE)…and yet another time when it lent $85 billion to AIG (NYSE:AIG).  Historically, bear markets can last months, or even years - so if you’re crossing your fingers that this one’s over, you might want to save your wishful thinking until 2009 or even 2010.

But if you’ve got a long term financial plan, and you’re looking for the right moment to jump back into the market, then one economic indicator you should pay close attention to is the TED spread.  The TED spread is calculated by subtracting the interest rate on treasury bills from the three-month Eurodollar LIBOR (T for T-bill, ED for “eurodollar”).  T-bill interest rates demonstrate the yield on a short-term loan to the U.S. government, perceived as nearly risk-free, while the LIBOR rate reflects the risk of a short-term loan from one bank to another.  

If the TED spread is relatively low, this means that inter-bank loans are perceived to be almost as stable as lending directly to the government - and the TED spread historically has hovered around 50 basis points, or a half a percent difference between the two rates.  

But lately, as the volatility of the market and long-term solvency of banks has come into question, the TED spread has become dramatically wider - as high as 460 basis points, a new record, on October 10th.  What this means is that banks are finding borrowing prohibitively expensive, tightening the credit markets, discouraging cash flow, and crippling economic growth.  

More importantly, the massive TED spread indicates a lack of confidence in the market, as banks hoard capital rather than lend to each other, sacrificing profit because the risk of default on the loan is simply too high.  Also factored in are lower yields on T-bills, as investors become willing to pay higher prices at auction and accept lower interest rates in return for the relative safety of guaranteed Treasury money.

So, if you’d like to evaluate whether the government’s Emergency Economic Stabilization Act (a.k.a Bailout Bill) is working, don’t watch the Dow Jones average, which reacts to the expectations, and fear, of retail investors.  Instead, keep tabs on the TED spread (you can find it here, on Bloomberg) and wait for it to come back to earth.  

Look for treasury yields to rise again as investors put their money back into stocks, corporate bonds, money markets, and other assets, and the inter-bank loan rate will come back down.  When this happens, banks and businesses can once again begin to borrow, and the economy will have the cash flow it needs to resume business as usual. 

That’s when earnings and stock prices might start growing once again - and your portfolio will stop the rollercoaster ride that you surely have not enjoyed watching in recent weeks.