Beware the TED Spread

The Financial market is scared. Paul Krugman, who The Economist said is "the most celebrated economist of his generation", writes in the New York Times:

Well, I’ve never seen financial insiders this spooked — not even during the Asian crisis of 1997-98, when economic dominoes seemed to be falling all around the world.

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Some credit markets have effectively closed up shop. Interest rates in other markets — like the London market, in which banks lend to each other — have risen even as interest rates on U.S. government debt, which is still considered safe, have plunged.

The TED spread is a measure of the confidence of the credit market. It is the difference between the 3 month LIBOR (London Interbank Offered Rate-- the interest rate that banks lend to other banks in the money markets in London) and the 3 month Treasuries (considered a risk free interest rate).

The TED Spread historically is under .75% and has been under .25% in the past few years. When the spread jumps, there is a perceived risk in the immediate future (next 3 months) that wasn’t there the previous month. Interestingly when looking at the S&P 500 since 1985, when the spread first goes over 1%, in the ensuing 3 months the S&P 500 has performed better than average. However, over the next 3 months (months 4-6), the market has underperformed.

The TED Spread did warn of the crash of 1987 and of the internet bubble of 2000. In May of 1987 the spread was at 1.7008. The S&P 500 hit an intraday high on August 25th of 337.89 before crashing in October when it reached an intraday low of 216.46 (35.9% down from peak). In May of 2000, the spread reached 1.2577. The market climbed to close at 1517.68 in August, 2000 and crashed to a low of 944.75 in September of 2001 (37.7% decline).

Click on the chart for a larger view.
The TED Spread is a good warning signal; bankers sometimes have reason to worry. And yet like Nobel Prize-winning economist, Paul Samuelson, once said, “Economists have correctly predicted nine of the last five recessions.”

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