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I'm hardly the only person paying close attention to the TED spread right now. Here's a few blog entries about it from Friday alone: 1 2 3 4 5 6 7 8 9 -- there was even a joking fight between Paul Krugman and Brad DeLong about who was responsible for making it "the consensus indicator of the depth of the current financial crunch".

But here's the thing: TED is the spread between three-month Libor and three-month Treasuries. Three-month Treasuries are a classic flight-to-quality buy: the place you go to when you want to just hide out in a cave and not get eaten by a marauding bear. Three-month Libor, on the other hand, is the rate at which banks will lend out their precious capital to another bank for a full 90 days: an eternity, in this market.

More to the point, if you're a bank, you really neither want nor need three-month interbank funding right now. Global central banks, led by the Federal Reserve, have flooded the system with so much overnight liquidity that you can get as much cash as you need, at a much lower interest rate, directly from your central bank, overnight. The choice between that and locking in a high interest rate for three months is a no-brainer.

Remember too that Libor is an indicative rate: it's the rate at which banks would lend to each other, if they were lending. If they stop lending, they still need to report some interest rate to the Libor committee. But it might well bear very little relation to banks' cost of funds in the real world, where the interbank markets are becoming increasingly dried-up and unhelpful.

Henry Blodget has a bank-analyst friend who thinks that the TED spread is crucially important:

The TED Spread, he explained, is 300+ basis points, and unless that changes, the whole system will shut down in a matter of days (the TED Spread measures the difference between 3-Month Treasuries and 3-Month LIBOR and represents how much many banks have to pay to borrow short-term money from each other. Banks either have to borrow or sell assets, the analyst said, and banks aren't going to borrow much at a 300bp TED when that's often bigger than their entire net interest margin.)

I think what the analyst is missing here is that so long as banks can borrow from the central bank overnight, the TED spread is largely unrelated to their real-world cost of capital. Which doesn't make me an optimist, by any means. But I do think that the TED spread can remain elevated for some time without the world coming to an end.

Source: Does the TED Spread Really Matter?