Farewell, TED Spread… See You Again, Soon?

I’ve written a few times about the TED Spread (e.g., here), that historically reliable indicator of systemic risk. I’ve updated the chart:

The TED Spread: 3-month T-bill vs. 3-month Eurodollar Deposit (LIBOR)

The TED spread has now returned to about 50 basis points, levels I would associate with the “normalcy” that preceded the Panic of 2008. There was always a question as to whether the TED would return to such low levels or would forever reflect some kind of unforeseen-event-risk (the “fat tail” of the probability curve that’s been much discussed in the trade). Cynics might argue that the TED returning to such low levels shows that market participants have learned nothing from the financial system’s upheaval. I prefer to see this as a recognition that the U.S. government does have the will and power to prevent a systemic meltdown (obviously, there are costs involved).

The TED’s narrowing is good news for the economy as it typically leads other credit spreads and allows the Fed to once again be in control of short-term interest rates. In this low rate environment, this translates to lower interest rates for borrowers, starting with adjustable rate mortgages tied to LIBOR. Corporate borrowers using short-term instruments are also direct beneficiaries. Those who borrow at longer term rates have a mixed picture — higher Treasury yields but narrowing credit spreads — by and large, the credit spread factor is now the more important ingredient so those borrowers are beneficiaries.

I’ve now been following the TED Spread for 23 years. For many, many years, the wisdom was that “the TED is dead,” forever locked in a narrow range (call it 30 to 50 basis points). I, like many others, simply stopped watching this important intermarket relationship. Has the TED gone back to this dormant state? I’m not so sure. For one, the TED has historically been impacted by the general interest rate level — that is, the higher the interest rate environment, the greater the TED spread, even given the same perceived credit risk.

Given the inflationary forces that the monetary and fiscal stimulus may unleash, I can easily envision a scenario where the TED widens on the back of Fed tightening. Moreover, our ability to successfully fend off a financial meltdown was partly due to the flexibility available in an environment with relatively manageable levels of government debt and limited inflation. Our ability to fix an unforeseen future crisis may be constrained by the costs of the policies we’ve employed to address the current situation. Given the advance warning that the spread signaled in 2007, I’ve made a promise to myself to keep an eye on the TED Spread for the rest of my career. I wish I could say, “goodbye” to TED, but fear it may really just be, “au revoir.”

Comments

[Jasper M:]

The bases for the spread has usually been perceived relative safety of Treasuries. Might one factor of the shrinking spread be a perception of reduction of that margin? If we act like we are going to try and print our way out our monstrous debt, does that imply that our paper is not much better than banks (who are getting first, all over the world)?

May 31 04:39 AM

[Clive Corcoran:]

The only thing I would modify in this sentence from your article is to change the word "may" to "will".
Our ability to fix an unforeseen future crisis may be constrained by the costs of the policies we’ve employed to address the current situation.

May 31 05:14 AM

[hooligan:]

Hah, a rising tide lifts all ships. The TED spread is lower because the Fed is now more risky than it has ever been, not because default risk has reduced amongst LIBOR type banks. It is entirely logical for the spread to contract when the Government finances all "junk" banks with Fed money. At the moment the credibility of the Fed is intact because the tax payer is not rioting from the crimes inflicted by the transfer of the taxpayers wealth direct to the banking system. Let's see what happens when unemployment hits 15% and 90% of americans living on less than $100,000 find themselves 10% worse off as a direct result of this wealth transfer in the next two years. New "clean" banks are needed, not this tainted corrupt rubbish bleeding the still profitable majority of the economy dry. The Fed can manipulate the short end, especially when the Government uses the "Paulson" approach of last October/November. In the end though, 50 unelected decision makers in a cartel of the Fed/Treasury will come a cropper. And not a moment too soon. The Fed is dead, and so are the banks on the ED side of the equation. A small margin between corpses does not change the fact they have expired.

May 31 10:37 AM

[ed233:]

The TED spread: isn't it like one of those economic barometers that reveals confidence concerning fluidity of commercial transactions? So when it starts to gyrate, it becomes a weather bell sounding an alarm concerning impending danger. It seems to me that this bell for the present has been silenced by huge injections of freshly printed bills(I owe you's). Borrowings and more borrowings and still even more borrowings for the purpose of propping-up a failed financial institution (under the guise of too big to fail), a failed auto industry that cannot succeed and the manipulation of bankruptcy rules to suit majority groups on the premise that too many jobs would be lost to do otherwise. To turn an eye against long established practices is like abandoment of true and tried underwriting rules for mortgage lending. Where did that practice lead the US housing industry? To plug every undesireable cavity for fear of Armageddon could bring on the very thing that isn't desired. The point of your article is a good one and the important line you write is" Our ability to fix an unforeseen future crisis may be constrained by the costs of the policies we've employed to address the current situation." LOL Looking after your money.

May 31 10:57 AM

[SoCalGal:]

Good writing demands that one first define an acronym [for example, TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract] before you use the acronym in the rest of the piece.

May 31 05:34 PM

[E Nuff Sed:]

The TED graph looks like an electrocardiograph. Clearly shows a "heart attack" in October - followed by a gradual stabilization under medication. As everyone knows after one heart attack there is a higher likelihood of another, unless the patient changes its lifestyle

May 31 07:15 PM

[hanumanhojo:]

Has the TED spread ever gone negative? If so, what did it mean?

Jun 01 12:58 AM

[Did U Think...:]

"I prefer to see this as a recognition that the U.S. government does have the will and power to prevent a systemic meltdown (obviously, there are costs involved)."

Wow. Well the way I see it is that complacency has gotten its teeth back into the market and the VIX shows this too. No, the fed does not have the power to control the markets. That is a myth. If it did then it would simply demand perpetual prosperity and we could all go home rich without doing any work. Sorry, it doesn't work like that. The markets are faaaaar bigger than all the governments combined. Wait until the herd starts to panic again and you will see Bernanke and Geithner either step aside or get trampled and the herd heads sounth. The fed is not all powerful as some think. It can perturb the markets in the short to medium term but it cannot mandate prosperity by fiat.

Jun 01 08:09 AM

[reluctantQuant:]

Ah, TED's an old and close friend of mine, always love seeing him in the news.
1. no, TED's always a positive guy, unless your government actually colapses.

2. TED directly shows the short term "psychotic factor" of the big bank treasurers. If they're happy, liquid and credit worthy, they offer LIBOR at comfy low levels, relative to Treasuries, while if they're starting to feel "horror show" inklings about deposits, borrowing and counterparty risk, they tighten up their offered lending levels (NCNB - No Cash for No Body). This is more important because it drives up the internal pool rate within the bank itself, increasing the hurdle rate for adding new assets (like making a long term loan).

3. At the end of the day, if the bank treasurer starts getting psycho, then everyone else around the bank has to get psycho, too, because it hits them in the wallet. That's why TED matters so much - it tells you what's going on with the cat who controls the cash.

4. For those who do care about the definitions, TED used to be the spread between the ED eurodollar futures and the T treasury bill futures, and not to be confused with any currency called EUR. But now, since the Tbill doesn't really trade anymore, TED is typically the difference between 3 month LIBOR and 3 month T-bills. This is also considered the "first stairstep" in the credit ladder and is very much a building block in interest rate swap spreads over longer terms. You'll also see TED's cousin a lot, Miss OIS. Some think she's much better looking and a bit more articulate than TED, but that's for another conversation.

Good article.
--rq

Jun 01 09:06 AM

[Harry Tuttle:]

Did you say 23 years?!

In my opinion, the biggest problem we have is that all the "analysts" seem to think the World was created recently.

The TED spread is where it is because the governments are explicitly guaranteeing the banks. Thus, although the spread is correct, I doubt it has the predictive value that you assign to it since we have NEVER seen in the past 23 years the governments guarantee the banks.

Jun 01 11:01 AM

[debtacid:]

If I want to read this kind of superficial tripe, I'd go to bloomberg or msn or yahoo or warket watch or wsj... This guys bio speeks volumes about why he should be ignored. Just another broken tool.

Jun 01 12:19 PM

[tunaman4u2:]

"Moreover, our ability to successfully fend off a financial meltdown was partly due to the flexibility available in an environment with relatively manageable levels of government debt and limited inflation. Our ability to fix an unforeseen future crisis may be constrained by the costs of the policies we’ve employed to address the current situation."

Great line... the NEW bubble is the government balance sheet just like housing in 2003... enjoy a few good years till the bubble bursts folks!

Jun 01 12:21 PM

[debtacid:]

If I want to read this kind of superficial tripe, I'd go to bloomberg or msn or yahoo or market watch or wsj... This guys bio speeks volumes about why he should be ignored. Just another broken tool.

Jun 01 12:21 PM