TED Spread - Inflation and Confidence in the Market
by John Seo
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Sophisticated investors, bank managers and government regulators use various metrics to measure and monitor the state of world finance. One such metric is the Treasury-Euro-Dollar spread or "TED spread." The TED spread is the difference between the interbank lending rate or London Inter Bank Offered Rate (LIBOR) and the rate on 3 month Treasury Bills. This difference is used by many "in the know," like chairman of the Fed, Ben Bernanke and bank managers, of the credit risk in the general economy. The TED spread uses the difference between the LIBOR and T-Bills because T-Bills are an entirely risk-free security in that the Federal Reserve could print more money to cover their outstanding obligations, and the LIBOR which is a measure of banks confidence, creditworthiness and liquidity. A higher number means greater uncertainty in the markets.
The recent mortgage crisis has lead investment firms to trend towards secure government instruments and away from from the open market. The largest TED spread in history was recorded in 2008 as the TED spread was higher than 400 basis points or 4 percent. There seems to be a direct correlation between inflation and a rising TED spread.
1) LIBOR
The LIBOR or London Interbank Offered Rate is is the daily rate at which banks lend unsecured funds to other banks in the interbank market. It is marginally higher than the LBID or London Interbank Bid Rate, the rate that banks offer to depositors. Another closely watched and often similarly priced interbank lending rate is the Federal Funds Rate, which is the rate that banks may borrow from the United States Federal Reserve.
The LIBOR is published daily at approximately 11:45a.m. London time by the BBA or British Bankers' Association. It is an average of interbank deposit rates offered by banks ranging from a year to overnight terms. The average is the interquartile mean, the average of the eight of 16 middle banking rates. Notice that while the LIBOR is a strong indication of interbank rates trends, the real rate at which banks lend to one another varies daily.
The LIBOR is often used in FOREX markets to gauge the rates at which currencies (Yen, Pound Sterling, HKD, US Dollar, Franc, Euro) appreciate.
2) Treasury Bills Notes and Bonds
The United States raises capital by issuing Treasury Bills (with maturity of one year or less), Notes (mature in two to ten years) and Bonds (mature between ten and thirty years). You can find the rates currently offered on the Treasury's website. These bills are issued by the United States Treasury Department through the Bureau of Public Debt. They also issue treasuries called TIPS that are supposed to protect against inflation. Similar to zero-coupon bonds, T-bills do not pay interest and are sold at a discount of par so that they appreciate until maturity. The shortest term treasury instrument publicly available is the 28 day T-bill.
To calculate the yield on a treasury bill you may use the following formula.
Percentage Yield = ((Face Value - Purchase Price) / (Face Value)) * (360 / Days Until Maturity)
It's interesting to find that the Treasury takes into account business cycles offering a higher rate on 20 yr bonds (4.41%) than 30 year bonds (4.14%) This raises the interesting question, why would anyone purchase the 30 year bond?
Treasury bond rates range from 0.66 percent for a one month bill to a 4.41 percent return on a 20 year bond.
3) Combat Inflation and Stagflation
The issue of inflation could span many volumes and you can expect future articles from us on inflation. For now lets just say that inflation is an economic term used to describe periods of increasing prices of goods and services and a decrease in the value of currency. It happens when the supply of money increases faster than the growth of the economy. The forecasted rate for U.S. inflation is rising dramatically and can be expected to rise as high as 6.74 percent over the next two years for an already depreciated dollar.
When inflation rises the central banks are tasked with careful control of currency circulation, regulating interest rates, fixing currency exchange rates, price controls and trade agreements and tarrifs.
The term stagflation is used during periods of inflation combined with slow economic growth and rising unemployment. The scary part of stagflation is that some of the treasuries tools, like interest rates, are rendered less useful due to the trade off between growth, inflation and employment.
Some proposed ways of fighting inflation and stagflation are to increase interest rates, lower tax rates, with the possibility of Keynesian money drops. An interested reader might be interested in Ben Bernanke's insights in Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment.
4) TED Spread
Again, The TED spread is the real difference between the 3 month interbank lending rate and the rate on 3 month Treasury bills. It is a strong indication of the growth of an economy, a larger TED spread signals slower growth and greater risk.
The TED spread seems to be a leading indicator of inflation and stock market movements.
5) Derivatives
Institutions may buy Chicago Mercantile Exchange Eurodollar contracts that are based on the three month interbank LIBOR rate.
One very important banking derivative to look at is the issue of over $50 trillion in interest rate swaps in America. Simply, an interest rate swap is where two parties agree to trade an equal amount of principle with varying fixed and variable interest rates, usually the "swap rate" and the LIBOR + basis points. This trade can be made in an interest to hedge against market forces or interest rate moves.