What does TED stand for?

TED is an acronym formed from T, for T-bills, and ED, for the Eurodollar futures contract.

What is the spread?

Originally the spread was between the interest rates for three-month US Treasuries contracts and the three-month Eurodollars contract as represented by the London Interbank Offered Rate (LIBOR).

However, ever since the Chicago Mercantile Exchange dropped T-bill futures, the spread is calculated as the difference between the three-month T-bill interest rate and three-month LIBOR (wiki).

How is the spread measured?

As you see in the chart below, the spread ranges from around between “50” and “500.” What do these numbers represent?

The chart below is in basis points, aka bps. For example, let’s say the T-bill rate is 4% and the ED trades at 4.5%, then the TED spread is 50 bps (.5%).

For all intents and purposes, between 10 and 50 bps should be viewed as normal. Anything greater can be viewed as a signal.

What does an increased spread signify?

When did the TED spread start becoming volatile? Well, by looking at the above chart you can see that it all happened in the second half of 2007.

And what was the stock market doing at the time? In October of 2007, the DOW was above 14,000 points. By the end of 2007 the DOW was already down to the lower 13,000s.

Why is this important? A rising TED spread is often looked at as a signal that the US stock market is about to head into a downturn because of an exodus of liquidity. The spread increases because whereas T-bills are pretty much considered risk free, LIBOR represents the risk involved with lending between commercial banks. If banks believe interbank loans are getting riskier because of default risks, they will increase the interest rates (hence liquidity lowers), thus increasing the TED spread.

How do we fix the TED spread?

Leaving all that mumbo jumbo behind, the TED spread is really just calculating the trust level between banks. If that’s what it signifies, then the next logical question is: Why did the TED spread fall so quickly in the above graph?

That is where the US government did a cash infusion into the banking system. Most people criticized the infusion by posting data that showed consumer lending was still down. And they are right. However, it is worth it to note that interbank lending premiums fell drastically, increasing liquidity in the economy.

Ripple into the consumer market?

At the time, it doesn’t seem the decrease in the TED spread is having a ripple effect in the consumer market. Consumer credit limits are being slashed every day, required credit scores for loans are increasing, loan rates are holding pretty constant, and more.

Why? It’s hard to say, but it could be that financial institutions are unsure of their models that price in risk. The saying goes “All models are wrong, but some are useful.” So they may be trying to re-evaluate some of their practices before extending credit into the consumer market again.

That’s All

That’s a pretty basic overview of the TED spread. But, I feel as if it shows the results of the recent cash infusion very well. Sometimes the benefits of economic actions are far beyond our observations, so it’s worth it to examine.

Hope this was interesting. If you have any questions or additions in regards to the TED spread or access to credit, shoot it over in the comments!