The TED Spread measures stress in the credit markets. It's looking a lot healthier.
The last two years have taught us all just how important the credit markets are for a robust economy and healthy stock market. I reckon, therefore, that all investors should take a close interest in any indicator that provides reliable evidence of the health of the credit market. The curiously named 'TED Spread' does just that -- and its current value and historical trends are freely available from many on-line sources.
So here I'll be explaining the TED Spread, providing some historical context and identifying why it is signalling that investment prospects are improving.
The fear of default
The TED Spread reflects the fear of default between banks, as it measures the difference between risk-free interest rates and the rates banks charge each other. Just as oil keeps your car engine running sweetly, credit, the availability and price of money, lubricates the national and global economy.
The TED Spread is the difference between three-month London Interbank Lending Rate (LIBOR) and the three-month US Treasury Bill (T-Bill) rate. TED derives its name from T-Bill and ED, the eurodollars futures contract (represented by LIBOR).
Well, that's the acronyms out of the way and into the open, but what does it all mean? And why is it important?
Safe as T-Bills
Well, US T-Bills are considered to be the safest investment available, issued as they are by the US government and backed by its strength, solidity and power. When you buy T-Bills you are effectively lending money to Uncle Sam and the rate of interest is risk free.
LIBOR is the British Bankers Association average of interbank lending rates. Basically it's the rate at which banks are willing to lend each other money. Usually that's also pretty risk free and so LIBOR is usually just a tad more than the T-Bill rate.
In the simplest terms, a small TED Spread is a sign of financial health. But if it's increasing then it could indicate big problems.
Say LIBOR is 4% and the T-Bill interest rate is 3.5%, then the TED Spread is 0.5%, or 50 basis points. Clearly, the narrower the spread the more credit worthy banks see each other and the healthier the financial system.
Money flows, via loans at reasonable interest rates, to companies and individuals, fuelling capital expenditure and personal consumption and thereby increasing the profits of the companies in which we buy and hold shares.
Stress in the system
On the other hand, when the TED Spread expands this is an unequivocal sign that mistrust in banks and the financial system is increasing. It doesn't take Warren Buffet to realise that's like a big red warning light flashing; because it indicates fear, which leads to risk aversion, which means shares are dumped in favour of so called 'safe havens'.
Historically, the TED Spread trends in a narrow range. Recent peaks were bad, but nowhere near the 1970s or 1980s.
Typically the TED Spread is under 50 basis points (0.5%), and it averaged 25 (0.25%) from 2002 to 2006. However as the credit crunch got going in the summer of 2007 it suddenly spiked up to 240 (2.40%) and averaged about 140 (1.40%) for the next year. Then, as Northern Rock crumbled and Lehman brothers collapsed in the autumn of 2008, it soared again; this time peaking at about 450 (4.50%) in October 2008.
TED Spreads of that size indicate that banks are unwilling to lend to each other at almost any price. Loans to industry and consumers evaporate and the economy hits the buffers. Needless to say, the media then enjoys a red letter day, running scare stories of "financial Armageddon."
As usual the truth is a little more boring. Yes, the TED Spread peaked at its highest since 1987 and the stock market crash of that year, but it never reached the dizzy heights of 600 (6.0%) it hit in 1974 or 500 (5.0%) in 1980. That's why all this talk of returning to a Great Depression is a load of tosh from economists who really ought to know better.
Back to reality
The TED Spread is currently signalling a return to trust and normality. It's a positive sign for investors.
The TED Spread is currently about 30 (0.3%), not far above the average of 25 (0.25%) I referred to earlier. It has been below 50 (0.5%) since May, clearly signalling a return to normality in interbank lending, thereby providing one of the foundations for repairing the economy and improving the equity outlook.
For those who wish to monitor the TED Spread, it can be found on the Bloomberg website. My positive stance would be reversed if the TED Spread started trending up, and especially if it trended between 50 (0.5%) and 100 (1.0%) for any length of time.
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