The TED Spread Suggests Fear is Abating

The press of popular opinion appears to be doing their utmost to convince the average mom and pop and wanabe trader that the World economy is about to fall into the abyss; that "here comes 1932". Beneath the scenes something very different is playing out and most commentators are missing it completely, or at least refuse to believe it!

Yes it is the TED spread and the USD Index. The TED is narrowing and has been doing so since mid June just a few days after the USD peaked out. Taking a step back for a bit what is the significance of the TED?

The TED spread is an indicator of perceived credit risk in the general economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. When the TED spread increases, that is a sign that lenders believe the risk of default on interbank loans is increasing. Interbank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the TED spread decreases.

Note, that the TED started to rise in mid March (yes easy in hindsight I know), but by the start of May it was already showing out-of-character behavior (so as far as the TED was concerned the flash crash and the ensuring collapse in May was no surprise). Anyway, what I am trying to say is that the TED foretold of problems (a breakdown in confidence) before May, and of course now it is foretelling that "confidence" is returning to markets. That is, from a liquidity perspective at least - which is at the heart of confidence as far as financial markets are concerned. It also helps that the big USD Index is confirming the action of the TED.

The confirmed "head and shoulders" formation on the Dow and the Dow Theory sell signal is one big bear trap. Watch the back end of the market, that will tell you everything you need to know.

Disclosure: Long VTI UDN

Comments

[John W. Taylor]

Does a shrinking of the TED spread indicate less credit risk in the overall market or just in commercial banks? It is possible that the establishment of "too big to fail" and other government regulations/actions has lowered the perceived default risk of commercial banks, but not the risk for the rest of the economy.

Jul 07 04:25 PM

[Daily Trading]

Yes I think it is suggesting that there is less credit risk in the overall financial market........banks willingness to lend to each other is little to do with banks themselves rather it is more to do with macro issues in the economy

Jul 07 04:37 PM