TED Spread Shrinking

As recently reported in a Bloomberg article and elsewhere, the TED spread has been shrinking, and a number of analysts are stating this as evidence that the economy is getting back on firmer footing. While the spread does get mentioned when it starts spiking, and correcting, it is not as widely followed as some of the other more popular indicators.

In short, the TED spread is the difference between the yield on 3-month Treasury bill interest rates and the 3-month Libor. It was originally the spread between the 3-month Treasury contract and the 3-month Eurodollar contract represented by Libor before the CME quit offering T-bill futures contracts - thus giving the name TED (Treasury - Eurodollar) spread. The current quote is around 0.8. The normal range is usually between 0.1% and 0.5%. The spread has been over 2% on three different occasions in the last year, and has been elevated above it normal range since August of last year. The combination of investors looking for the safety of Treasuries (driving prices up and yields down), while incurring higher borrowing costs due to credit issues (driving 3 month Libor yields up), have increased the spread over the last year.

But now the spread is decreasing. Does this imply that all is clear in the economy? Maybe, but maybe not. A decreasing spread is a sign that liquidity is increasing, reflecting at least in part the success of the recent unconventional Federal Reserve actions to increase liquidity. The overnight Libor rate has dropped to around 2.11%, the lowest value in three and a half years. The 3-month rate has also declined to around 2.66%. Yet lenders still continue to hold cash, given that the Libor-OIS spread, the spread between the 3-month loans and the overnight indexed swap rate, is still around 0.66%, compared to an average rate of about 0.11%.

In fact, when you dig deeper, as discussed at the WSJ marketbeat blog, the recent narrowing of the TED spread is due mainly to an increase in T-bill yields which have risen by about 1.25% in the last few months. This has had a bigger impact than a drop in Libor, which has only fallen about 0.25% in the last month. As a result, traders are not as impressed, at least not quite yet. If the situation was reversed, where Libor was falling by 1.25%, this would imply that the liquidity issue and credit problems were abating, but this is not yet being indicated by the action in Libor. Instead, the T-bill supply is above average, putting pressure on prices and raising the yields, thereby lowering the spread. Things are improving, but it may still be too early to assume the credit and liquidity problems are behind us.