The TED spread
At the height of the Lehman’s crisis, one of the most watched statistics was the so-called ‘TED spread’.
This is again the focus of attention as investors assess on the risk of governments, not just banks, defaulting. So what exactly is this spread? The term itself derives from ‘T-Bill’ and ‘ED’, the screen symbol for the eurodollar futures contract. It now measures the difference between the interest rate on interbank loans (as represented by LIBOR) and the implied interest rate on short term US government debt (Treasury- , or T- Bills).
Because T-Bills are seen as risk free, while LIBOR reflects the credit risk of lending to commercial banks, the TED spread is seen as a good indicator of credit risk - the spread increases when inter-bank lenders demand a higher rate of interest, or accept lower returns on safe investments such as T-Bills, or a bit of both. LIBOR plays a huge role in the pricing of credit (such as floating rate mortgages) to individuals, and to businesses, so a rise in the spread amounts to monetary tightening.
A rising TED spread will also often presage a downturn in equity markets as it shows that liquidity is being withdrawn. Until 2007, the spread was between 0.1per cent and 0.4 per cent, or between 10 and 40 basis points. The credit crunch saw this move much higher, and at the peak of the crisis on 10 October 2008, it reached a record of 463 basis points (higher than after the Black Monday stock market crash of 1987). As banks were nationalised, interest rates cut and central banks bought bonds from the private sector (‘quantitative easing’, a.k.a. printing money), the spread gradually fell back again to a low of 9.5 basis points (0.095 per cent) in mid-March 2010. Since then it has climbed ominously… does this foretell a Greek sequel to the credit crunch? Possibly… but while current levels are high compared to the cheap money days of 2000-2007, they are actually lower than the levels seen between 1990 and 2000 (and these were lower than in the 1980s).
No doubt the European sovereign debt crisis has pushed the spread up. But technical factors have made it worse; for example, changes to how derivatives are traded will affect the banks’ appetite and ability to lend to each other.
Lastly, US policy makers reacted promptly to the Lehman’s crisis by ensuring that banks could borrow cheaply – for example, the Federal Reserve (the ‘Fed’) undertook to buy huge amounts of mortgage-backed securities (MBS). Now the US has turned off the tap – the Fed stopped buying MBS at the end of March. It is surely no coincidence that since then, the TED spread has inched upwards.
James Codrington is head of charities at Baring Asset Management
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