The Long Term Perspective on the TED Spread

Here is the usual picture of the TED spread from Bloomberg.
Ted_spread_bloom_2
I was curious to see a longer-term picture so I collected data on the 3 month Treasury bill rate (TB3MS from the St. Louis Fed.) and the 3-month Eurodollar rate (EDM3 from the Fed.)  Note that this is current up to September.  Also this is slightly different from calculations elsewhere because it’s on a monthly basis, so some daily jumps are smoothed out, and sometimes a different LIBOR rate seems to be used for the ED rate but the different versions appear to correlate well.  The advantage of using these measures is that you can get a much longer time series.  Here it is (click to expand if unclear).
Ted_long_2

Comments

Can someone explain in laymans terms why the TED spread is important and what it means?

Thank you.

Oh that's a relief. So the TED spread has only been the worst it's been since 1974. I don't know what all the fuss is about.

The TED spread is an indicator of credit risk. Lower TED demonstrates lower percieved risk of default on interbank loans.

Alex:
I can guarantee you that it looks at LOT scarier as a ratio, try this edm3/tb3ms

i will add another comment mentioning the ratio of the two. when treasury rates are in the double digits a larger spread should be expected on an absolute basis.

when 3mTBill rates are at or near zero, a spread of 300 bp is scarier. especially since you have tools to reduce the Tbill rate (fed funds is a direct substitute) and once you're at zero on the bills there's not much else you can do.

jck, why look it as a ratio? Isn't the spread the theoretical risk premium? This is an honest question, wondering what I'm missing. Thanks!

the spikes in the 70s and early 80s were when interest rates were much higher.

That is a lot scarier...

Also, it should be noted that the first interest rate swap wasn't until 1982, and the first swap was in 1980.

In general, very long term charts of the ted spread are not useful.

jck,

Nice chart and blog, read you all the time.

From the ratio chart you can see how out of wack the .tedsp index is right now.

I understand theoretically why it is called a spread and not a ratio. A bank has a choice of giving money to the government risk-free or to another bank for a slightly higher yield. The spread factors in the risk of a bank defaulting, regardless of what the underlying T-bill rate is.

However, why was the TED spread so much higher then pre-1985 than 1985-2007. Right now, I can only think one explanation. Pre-1985, banks were much more regionalized and Podunk National Bank would typically only use deposits to finance lending. A bank asking for loans from another bank was a signal of a bank possibly in trouble. Since 1985, banks became more consolidated and they realized it was very unlikely for another big bank like BoA or Citi to fail.

I think TED is interesting, but not relevant for economic policy.

It is the increase in the LIBOR that is the problem, not the drop in the T-Bill rate.

If the higher interbank lending rate is resulting in higher interest rates for final borrowers, and so, consumption and investment are depressed, then, a more expansive monetary policy to maintain spending is waranted. And that would tend to lower interest rates--most rapidly the interest rate on interbank loans and then on other loans.

Simiarly, that there is a large gap between higher and lower risk commercial paper rates, closing the gap shouldn't be the goal. The goal should be to lower the rates on high risk and lower risk borrowers so that the decrease in borrowing by the high risk borrowers is dampened, and offset by the increase in borrowing by low risk borrowers.

To the degree that the expansive monetary policy lowers the T-Bill rate more rapidly than other interest rates--so what? The gap is not the problem.

However, LIBOR is a poor measure of the cost of interbank lending.

LIBOR is an average of the interest rates that 20 major money center banks pay on short term loans.

If you assume that these are the soundest institutions, then, everyone else would, naturally, be paying more.

However, what has happened is that large money center banks are paying more than everyone else. (The TED is a measure of lack to confidence in large money center banks.)

The Fed tracks actual federal funds transactions. This is all the interbank lending, not just the 20 large money center banks. Actual Federal Funds transactions are below target. Often less than 1%.

Some banks are lending to other banks. It is just that the 20 money center banks whose borrowing rates are tracked by LIBOR are paying high rates.

The CD rates tracked by the Fed tell the same story. These are on the secondary market--in other words, negotiable CD's issued by large, money center banks. The rates on these are very high.

If we look at the banking system as a whole, deposits are expanding. Persumably, funds are moving from large money center banks (and from money market funds, and from direct investments in commercial paper) into bank deposits.

Bank credit is expanding. Higher risk firms that had borrowed by issuing commercial paper are now borrowing from banks.

So what if they are using lines of credit? That is what lines of credit are for.

Banks aren't lending? False. They are lending, but maybe not the same banks are lending to the same people as before.

Oh people, please stop arguing using TED ratios. Spread is a risk price, but the ratio of spread to risk free rate is economic garbage. You could make the graphs look even scarier by multiplying the time series with exp(g*t), g>0. But again you only get garbarge.

The risk free rate expresses the pure time preference of economic agents (influences the willingness to shift consumption intertemporally). The spread expresses the willingness to enter riskier intratemporal bets. They are two different concepts. The spread, as a measure of the risk price, has exactly the same meaning regardless of what the level of the risk free rate is.

Have we moved to a situation where we evaluate the relevance of economic indicators based on how scary they look like?

Such a great post. Thank you.

Its not just "risk" in the traditional sense. As part of what you are calling "risk" you need to take into account inflation.
1) The banks can put their money into forms that are more secure against inflation than cash or loans.
2) Inflation for 2008 has been in the 4-5.5 percent range, so the banks have a high opportunity cost for keeping their money in assets that aren't inflation resistant.
3) The TED Spread in part reflects this opportunity cost for the money.

Now, prices for almost everything are dropping (Yes Iron ore doubled, but that was more due to china restricting imports of scrap metal) so, inflation should start dropping too.
-- If I am correct, soon after inflation starts dropping the TED Spread should also drop.
-- If I am wrong and it is traditional "risk" that is being reflected, the dropping inflation shouldn't be mirrored by a dropping TED spread.

JSK, the TED Spread is a real spread. You are subtracting two nominals so inflation cancels out.

David Altig beat you to this:

http://macroblog.typepad.com/macroblog/2008/10/how-high-is-fin.html

@anon: Nah.. subtracting nominal interest rates does not mean 'cancelling out' inflation, because real interest = nominal interest/price level change. Don't mean to sound snarky, but this is basic mathematics.

JSK: The interest rates are in logs, so anon is of course right. Even if you measure them in levels, then his argument is correct to the first order. Your argument does not make sense. As you say, it's just basic mathematics.

The relationship between real (r) and nominal (i) interest rate (measured in logs) is EXACTLY
i = r + pi
where pi is the inflation rate. When you measure it in levels, then this is the first-order approximation of the formula
(1+i) = (1+r)*(1+pi).
If you have two nominal interest rates, like the risk_free i_rf and the risky i_r, their spread is
i_r - i_rf = r_r - r_rf
So the spread is invariant to taking real or nominal interest rates. With interest rates measured in levels, you just calculate
(1+i_r)/(1+i_rf) = (1+r_r)/(1+r_rf)
and it's again the same, and a first order approximation of this leads to the formula above.

mickslam: I stay behind my claim. It is 50bp of additional returns, and it can be translated into the same preference relation using the weak axiom of revealed preference, regarding of the level of the nominal interest rate. You probably want to claim that a 50bp change at a higher level of the risk-free rate will lead to a lower price change. You are right, but this is not what investors care about. Investors do not care about DIFFERENCES in prices, they care about price RATIOS. This is what all asset pricing equations tell us. Price ratios lead to returns, price differences do not lead to anything. And in terms of price ratios, 50bp of additional returns is the same, regardless of the level of the risk-free rate.

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