Update on the TED Spread

Here is an update on the TED Spread - the difference between the 3 month treasury and the 3 month Eurodollar rate. This measures the amount of perceived risk to lend to a banking counterparty. From 2002 to 2006 the spread averaged .288. Currently it is at 1.14 (as of 8/15/08).

The spreads reached very high levels in the 70s and early 80s when inflation was running rampant. The spread reached a high of 5.97 in July of 1974, and the Eurodollar rate was 13.52%. This next chart shows the spread as a percentage of the Eurodollar. This allows for comparison of the TED Spread during periods of high inflation and lower inflation. Using this matrix, the current spreads are at historic highs. The chart also shows the year over year change in the S&P 500.

The following chart shows the daily fluctuations of the TED Spread. Looking at the TED Spread, it looks like the current credit crisis has gone through 4 waves where the TED Spread has gone over 1.5.

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The Fed Minutes Spook the Market

The Federal Reserve's April meeting minutes were released today. They believe that the threat of the credit crisis has dissipated.

Although participants anticipated that further improvement in market conditions would occur only slowly and that some backsliding was possible, the generally better state of financial markets had caused participants to mark down the odds that economic activity could be severely disrupted by a further substantial deterioration in the financial environment.

The TED spread has lessened in recent weeks to under 1%, the lowest it has been since July 2007.

However, compared to January, the Fed's forecast has changed considerably. The projections of the Federal Reserve Governors and Reserve Bank Presidents for real 2008 GDP growth now range from 0.0% to 1.5% (down from 1.0% to 2.2% in January). The projections for the Unemployment rates range from 5.3% to 6.0% (was 5.0% to 5.5%). The projections for PCE inflation ranges from 2.8% to 3.8% (was 2.0% to 2.8%). The Core PCE inflation projections range from 1.9% to 2.5% (was 1.9% to 2.3%).

Due to the improvement in the Financial markets and the threats of inflation, the Fed signaled that they are probably done with the rate cuts. The possibility of the rate cuts combined with the gloomy economic projections spooked the markets today.

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Ted Spread remains at a high level; maybe being kept artificially low

The Wall Street Journal had an article on the LIBOR and how the rates could be artificially low. Here are some excerpts from the article:

Libor plays a crucial role in the global financial system. Calculated every morning in London from information supplied by banks all over the world, it's a measure of the average interest rate at which banks make short-term loans to one another. Libor provides a key indicator of their health, rising when banks are in trouble.
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The concern: Some banks don't want to report the high rates they're paying for short-term loans because they don't want to tip off the market that they're desperate for cash. The Libor system depends on banks to tell the truth about their borrowing rates. Fibbing by banks could mean that millions of borrowers around the world are paying artificially low rates on their loans.
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In a recent research report on potential problems with Libor, Scott Peng, an interest-rate strategist at Citigroup Inc. in New York, wrote that "the long-term psychological and economic impacts this could have on the financial market are incalculable." Mr. Peng estimates that if banks provided accurate data about their borrowing costs, three-month Libor would be higher by as much as 0.3 percentage points.
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The Libor system was developed in the 1980s. Banks were looking for a benchmark that would allow them to set rates on syndicated debt -- corporate loans that typically carry interest rates that adjust according to prevailing short-term rates. By pegging lending rates to Libor, which is supposed to represent the rate banks charge each other for loans, banks sought to guarantee that the interest rates their clients pay never fall too far below their own cost of borrowing.
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When banks want to borrow money, they contact banks directly or phone a loan broker, such as ICAP PLC in London. Much of the interbank lending takes place between 7 a.m. and 11 a.m. London time. In broker speak, a bank might ask for a "yard" -- one billion in a designated currency. Brokers communicate with bank clients by phone or through desktop voice boxes, which are faster. At ICAP, brokers track bids and offers by looking up at a big whiteboard above the trading floor, where a "board boy" posts information. The actual rates at which banks borrow from each other are known only to the lenders and borrowers, and possibly to their brokers.

Every morning by 11:10 London time, "panels" of banks send data to Reuters Group PLC, a London-based business-data and news company, on what it would cost them to borrow a "reasonable amount" in a designated currency. The dollar Libor panel, for example, consists of 16 banks, including U.S. banks Bank of America Corp. and J.P. Morgan Chase & Co. and U.K. banks HBOS PLC and HSBC Holdings PLC. Reuters uses the reported borrowing rates to calculate Libor "fixings." To reduce the possibility that any bank could manipulate an average by reporting a false number, Reuters throws out the highest and lowest groups of quotes before calculating averages.

Justin Abel, global head of data operations for Reuters, said in a statement that his company's role is solely to calculate fixings based on the information provided by banks. "It is their data alone we distribute. Reuters is purely the facilitator," he said.
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Citigroup's Mr. Peng believes banks could be understating even those abnormally high Libor rates. He notes that the Federal Reserve recently auctioned off $50 billion in one-month loans to banks for an average annualized interest rate of 2.82% -- 0.1 percentage point higher than the comparable Libor rate. Because banks put up securities as collateral for the Fed loans, they should get them for a lower rate than Libor, which is riskier because it involves no collateral. By comparing Libor with that indicator and others -- such as the rate on three-month bank deposits known as the Eurodollar rate -- Mr. Peng estimates Libor may be understated by 0.2 to 0.3 percentage points.

I periodically post updates on the TED Spread - the difference between the 3 month treasury and the 3 month Eurodollar rate. This measures the amount of perceived risk to lend to a banking counterparty. From 2002 to 2006 the spread averaged .288. Currently it is at 1.42. You have to go back to the stock market crash of 1987 to see the spreads that high.



The spreads sometimes reached very high levels in the 70s and early 80s when inflation was running rampant. The spread reached a high of 5.97 in July of 1974, and the Eurodollar rate was 13.52%. This next chart shows the spread as a percentage of the Eurodollar. This allows for a more equal comparision. Using this matrix, the current spreads are at historic highs. The chart also shows the year over year change in the S&P 500.

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Update on the Interest Spreads

Here is an updated chart of the interest spreads. They were discussed in more detail in this earlier post.

The spread between Moody's Baa to the 10 year Treasury and the TED Spread are still at high levels indicating that the credit crunch still remains.

The S & P 500 has droppped over 20% in a one year time frame just 5 times since 1971 (in 1973, 1981, 1982, 1987, and 2001). The TED Spread was over 1.2% less than 3 months before the peak was reached in each of those 5 times. There many times where the TED Spread doesn't reach this level for years at a time. The S&P 500 is currently down 15.8% from the most recent high reached in October 2007. The TED Spread was at an elevated level this time around as well.

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Interest Spreads

With the Fed lowering the rates quickly over the last two weeks, the Federal Funds target rate is once again below the 10 year Treasury. It had been lower than the 10 year Treasury (making it an inverted yield curve) for most of the last year and a half. The yield curve has inverted in all 6 previous recessions.

The Fed Funds has dipped below the 10 year Treasuries 4 other times since 1962 without formally entering a recession. In 1966, the yield curve inverted without a recession, however, the S &P 500 dropped 23.7% from its high to low during that period. The Fed Funds also dipped below the 10 year Treasuries once in the mid-eighties and once in the mid-nineties and again in 1998 (Long Term Capital Management blowup). However in all cases the 1 year Treasury did not dip below the 10-year Treasury.

The TED Spread is the difference between the Treasury and the EuroDollar (T-ED). The TED Spread is a good barometer of the short term risk perceived by banks. It has come down a bit from its recent levels, but is still at an elevated level.

Companies receiving a Moody’s Baa ratings are considered to be medium grade risks. The spread between Moody’s Baa and the 10 year Treasury is at a high level right now showing the effects of the credit crunch. However, the Baa spread does not seem to have as much correlation with the S&P 500 and the economy. It often peaks a year after the recovery has begun.

It takes time for rate cuts to affect the economy. The yield curve often turns positive very early in the recession stage. In 1989, the yield curve turned positive right before the recession started. In 2001, the yield curve turned positive just weeks after the official start of the recession.

Here are charts going back to 1962. You can click on the charts for a larger view.

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TED Spread

Here is an updated chart on the TED Spread. Here was the original post on the TED Spread. The TED spread is one of the warning signals of the possible upcoming recession.

The 3 month LIBOR has dropped over the last few weeks by nearly .50% from where it was at in December to 4.44% yesterday. The spread has narrowed to 1.4 which is still quite high. It spiked up for little over .5 to 1.49 in August of 2007.

The recent drop in the TED Spread indicates a small improvement in the credit environment, but we are still at very elevated levels.

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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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