TED Spread and the U.S. Market

This week I’m going to focus on the TED spread and what it can tell us about the U.S. stock market. I see this series taking three parts: (1) the TED spread as a lagging indicator of the stock market, (2) as a leading indicator, and (3) predicting the TED spread itself.

The TED spread has garnered a lot of press recently because (a) it’s viewed as a gauge of credit risk– an important indicator in this credit driven crisis, and (b) in the last couple of months, it has reached historic highs.

click to enlarge

The graph above shows the TED spread (blue) versus the 3-month U.S. T-bill rate (red) and 3-month LIBOR rate (green) denominated in U.S. dollars through October 22, 2008. The individual rates are scaled on the left axis, and the spread on the right axis.

A two-second definition of the TED spread: The TED spread is calculated by subtracting the U.S. T-bill rate from the Eurodollar LIBOR rate. Because LIBOR accounts for the credit risk of lending to banks while the T-bill is viewed as risk-free, an increasing TED spread is an indicator that lenders believe counterparty risk (or the risk of default on loans to other banks) is increasing.

Again, it is an important indicator when the crisis that ails you is very much driven by credit fears.

Comments

[John Lounsbury:]

I see no relationship between the title of this post and the article. Where is the analysis?

2008 Nov 05 11:24 AM