Watch The TED And LIBOR-OIS Spreads For Market Signals

It doesn't matter if you're looking at the TED spread or the LIBOR-OIS spread, both are telling you banks are nervous about lending to each other. Back in 2007 and 2008, when these measures spiked, few retail investors were familiar with them. Today, their direction is arguably must-know news. Why? Because they tell you when institutions are shutting off liquidity, which is the lifeblood of GDP growth.

What is the TED Spread?

Let's start with the TED spread. The TED spread measures the difference in yield between the U.S. 3-month Treasury and 3-month LIBOR. So what is LIBOR? Like most people and corporations, sometimes banks need to borrow money. And, as incestuous as it sounds, they borrow from each other. The London Interbank Offered Rate ("LIBOR") is the daily rate banks charge each other for those loans. During good times, money flows freely and cheaply between them. But during bad times banks demand more interest to make up for the rising risk of default. As you can see, LIBOR is a telling indicator of how nervous banks are of one another. A higher LIBOR usually means banks are increasingly nervous they won't get their money back from the other bank.

Treasuries have a certain standing of confidence in markets, with the US Treasury providing one of the safest havens during periods of economic distress. As a result, when markets get iffy, investors pile into Treasuries, which pushes down the yield. When we consider these two confidence-busting events together, falling Treasury yields and rising LIBOR means economic trouble.

What is the 3-Month LIBOR-OIS Spread?

The 3 Month LIBOR-OIS spread is the difference between LIBOR and the overnight indexed swap (OIS). The OIS is derived from the overnight rate, which is typically fixed by central banks. So, in the States, the OIS reflects the Fed Funds Rate. As a result, the OIS lets LIBOR banks borrow at a fixed rate over a specified time.

Importantly, the LIBOR-OIS spread, like the TED spread, tells investors how nervous banks are of each other. If LIBOR heads higher, widening the spread to the Fed Funds Rate, it’s a signal of shrinking liquidity. When prices rise, such as for loans between banks, it increases funding costs, reduces demand and takes away -- in the form of higher financing costs -- additional money which could be lent.

The liquidity spigot is trickling.

Unfortunately, these measures are telling investors to be very careful. Since September 2009, the TED Spread has typically ranged between 10 and 20 basis points. During economic crisis it gets much higher. It spiked as high as 457 basis points in the fall of 2008, when Lehman and Bear Stearns were collapsing. It got up around 300 basis points on Black Monday in 1987.

From May through most of July this year, the TED spread ranged from roughly 20-25 basis points. In August, however, it broke out above 25 basis points, retested and made a higher low, before breaking out to new highs.

Currently, at 36.19 basis points it’s just shy of its highs from last week, and a bit below its summer 2010 highs near 40 basis points.

As for the Libor-OIS spread, it typically ranges plus or minus 10 basis points. During the fall of 2008, it got up to 364 basis points. In 2011, the LIBOR OIS spread has been as high as 18 basis points in April and as low as 12 basis points in June. It made a new high in the first week of August and has marched steadily higher, trading to 29 basis points on September 19. After a short pullback in the wake of positive comments from Treasury Secretary Timothy Geithner and hopes surrounding a European fund to buy troubled sovereign debt, it has climbed back to 28 basis points.

New highs for spreads may mean new lows for stocks.

Summer is a notoriously tricky time to own anything in the stock market, but the final quarter is typically more rewarding. As a result, investors are more willing buy on pullbacks through the first couple weeks of October. The problem, however, is determining how much lower markets may fall.

The TED Spread, or LIBOR-OIS spread, may tell you when the time is right to take on risk. As it stands, the TED spread is already testing its recent high. If it takes this level out, and its summer 2010 high near 40 basis points too, you'll want to be short the stock market or in cash. Similarly, if the LIBOR-OIS spread moves above its recent high of 29 basis points, you'll want to be short or in cash.

Finally, watch the spreads daily to see if they conflict with the stock market action. If spreads are rising with the market, sell stocks and take some profits. If they are falling with the market, buy some stocks for a trade.

Disclosure: I am long SDS, QID.