Narrowing TED Spreads Point to Lower Default Risk

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The TED spread (i.e. three-month dollar LIBOR less three-month Treasury Bills) is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR (i.e. the interest rate banks charge each other) reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. On the other hand, when the risk of bank defaults is considered to be decreasing, the TED spread narrows.

Since the TED spread’s peak of 4.65% on October 10, 2008 the measure eased consistently, but edged up from the March low (10.57 basis points) to mid June (48.64 basis points). Subsequently the default risk has once again declined to the current level of 27.44 basis points. (click to enlarge)

Source: Fullermoney

The difference between the LIBOR rate and the overnight index swap (OIS) rate is another measure of credit market stress.

When the LIBOR-OIS spread is increasing, it indicates that banks believe the other banks they are lending to have a higher risk of defaulting on the loans so they are charging a higher interest rate to offset this risk. The opposite applies to a narrowing LIBOR-OIS spread.

The movement in the LIBOR-OIS spread over the past few weeks is similar to the TED spread and shows that risk is declining. (click to enlarge)

Source: Fullermoney