At the end of 2008, the credit crisis led many to fear that banks of all size and shape may fail; thus banks themselves weren’t willing to do business with each other. Credit, at the heart of the financial system, was frozen.
Today, that story is vastly different as evidenced by the TED spread.
The TED spread is likely a term you’ve likely never heard. It represents the difference between interest rates that banks charge each other (aka London Inter Bank Offering Rate — LIBOR) versus short-term U.S. government debt (Treasury bills). TED is actually an outdated acronym based on T-Bill and ED, which is the symbol for the eurodollar futures contracts.
Client deposits, withdrawals and other activities require banks to manage their own short-term liquidity needs. To do this, they essentially rely on other banks for short-term lending. Consequently, the TED spread compares the confidence banks have towards each other versus government policy towards interest rates.
On Oct. 10, 2008, banks charged each other 4.8 percent for short-term loans to each other (LIBOR), while 3-month T-Bills stood at 0.2 percent — hence the TED spread stood at 4.6 percent (or 460 basis points). In a healthy banking environment that spread typically ranges from 0.2 percent to 0.5 percent (20 to 50 basis points). 4.8 percent is an historically huge number. This occurred at the same period when confidence in all investments reached a low, and the markets tumbled.
In fact, the TED spread remained north of 1 percent from August 2007 through April 2009; still twice that of a normal environment.
Finally, in May of this year, banks began offering each other more reasonable terms and the spread dropped below 1 percent. Judging by your more recent investment-account statements, you’ve likely appreciated this healing of confidence.
Today, the TED spread stands at 0.2 percent (20 basis points); evidence of a normal interbank-lending environment.
As asset values have been highly responsive to the credit environment, we very well could experience further market strengthening under the conditions that the TED spread remains intact, earnings continue to recover and the economy grows. On the other hand, with a high proportion of option adjustable mortgage rate resets on the horizon, many banks still overleveraged and unemployment heading to 10 percent, it would not surprise me to see an increase (widening) of the TED spread and perhaps a pullback in the stock markets at some point in the next several months — but that is speculation.
Either way, the TED spread, to me, is somewhat like taking someone’s temperature: If it heads above 100 (basis points), seek medication (i.e., call your adviser). To check the TED spread online, Google the words
“Bloomberg TED spread” and visit the Bloomberg link.
Brown, CFA, is founder of Laureola Asset Management Co. He was a director for Prudential’s Strategic Investment Research Group. His formal education includes a master’s degree focusing in economics from Drexel University (1997) and a bachelor’s in economics from Indiana University of Pennsylvania (1993). Brown has been a chartered financial analyst charterholder, and is president of the CFA Society of Naples. Check his blog, Jack Brown, INVESTigator, at naplesnews.com/blogs