Don't Forget The TED Spread

Includes: DIA, IWM, QQQ, SPY
by: Calafia Beach Pundit

This blog has paid a lot of attention to swap spreads over the years, in the belief that they are good coincident and leading indicators of systemic risk and economic and financial market health. Swap spreads have been very low of late, despite the turmoil in the oil patch, which has sent spreads on high-yield energy-related debt to levels not seen since the height of the 2008 financial panic. I think that means that the problems in the oil patch are not likely to spread to other areas, in the way that problems with mortgage-backed securities spread to the global economy in 2008. Why? Because swap spreads tell us that liquidity is abundant (thanks to QE) and the financial markets are thus able to fulfill two of their primary roles, which is to spread risk around and, through the magic of markets, find prices that match sellers to buyers, and that balance the supply of and the demand for commodities such as oil. Markets can almost always solve problems if left to their own devices, and if central banks respond to crises by providing needed liquidity.

A related indicator, lost in the QE shuffle of the past 7 years, is the TED spread, which stands for the difference between the yield on 3-mo T-bills and 3-mo Libor (T-bills/euro dollars). It is a direct measure of the premium that investors demand for accepting the risk of loaning money to a bank rather than to the U.S. Treasury.

As the chart above shows, that spread soared to more than 300 bps at the height of the 2008 financial crisis, an indication that the world was deathly afraid that more banks would collapse in the wake of the Lehman failure. The TED spread also soared in late 1987, as the S.E. Asian currency crisis blossomed and entire banking systems overseas were threatened. The spread rose for years prior to the 2001 recession, accurately signaling developing problems. In contrast, the current level of the TED spread, 34 bps, is about what it equals during periods of relative calm.

The chart above shows the evolution of the TED spread (the bottom half of the chart) and its components (top half). What it also shows is that the Fed's efforts to raise money market rates through its IOER reverse repo program are working.

This last chart shows just the yield on 3-mo T-bills, often referred to as the bedrock risk-free rate for the entire world. That this rate has risen from zero to 28 bps against the backdrop of a global financial panic in recent weeks is notable, to say the least. If global conditions were truly calamitous, the Fed's efforts to raise short-term rates arguably would have proved futile, as there would have been an overwhelming demand for the safety of 3-mo T-bills.

Bottom line, the underpinnings of financial markets look reasonably solid, and that offers the promise that the turmoil in the oil patch will be resolved without plunging the world into another 2008-style crisis.