Watch The TED And LIBOR-OIS Spreads For Market Signals

Sep. 29, 2011 8:16 PM ETSDS, QID, DXD7 Comments

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

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