"TED spread" is a term given to the metric of credit default probability as measured by the difference between a major lending interest rate and the interest rate on a government's securities. For example, the TED spread can be calculated as the difference between London Interbank Offered Interest Rate (LIBOR) and U.S. Treasury bill interest rates. (econbrowser.com) The larger the difference between the two values, the greater the chance of a credit crisis or an existing credit crisis is. This article will discuss the TED spread in terms of the U.S. Treasury Bills and the U.S. Interbank lending rate.
To determine the intensity and level of a credit crisis, the TED spread between U.S. Treasury Bills and the Interbank lending rate of a same time period can be used. For example, the difference between the three month lending rate for both hen banks lend to each other there is risk; a quick and simple way this risk is measured is by use of the TED spread which compares federal reserve bank determined interest rate risk calculations with the interest rate of U.S. government Treasury Bills. Interest rate risk could be assessed by simply monitoring the movement of the Interbank lending rate over time, however the TED spread provides a more immediate solution to gauging market risk and is often published on financial websites and newspapers.
To illustrate the analytical benefits of the TED spread there are several financial and/or economic dynamics involved with what the number represents. These dynamics or financial relationships are composed of financial factors that include 1) Federal Reserve Bank decision making 2) perceived market lending risk on Interbank loans and 3) Spread or difference between two different interest rates.
Since the Federal Reserve Board assesses and determines the Interbank lending interest rates, it is logical to assume some economic analysis and risk assessment is incorporated into the interest rate. Secondly, since economics is not an exact science, there is a fractional factor of perceived and/or subjectively determined market conditions in the Interbank lending rate. Third, the difference between government loans and bank loans as measured by the Treasury bill interest rate and the Interbank lending rate illustrates a corresponding difference in risk, where the lower the difference, the lower the risk and vice versa.
Financial analysts, investors, economists, bankers and others refer to the TED spread to assess how the Federal Reserve Board judges commercial health of an economy. This in turn can lead to more conservative or liberal financial decisions based on other important metrics such as GDP growth, the unemployment rate, inflation etc. The latter of these metrics i.e. inflation is also important as the issuance of Government Treasury Bills is also tied to inflation.
Specifically, the higher the interest rate on Treasury Bills, the higher inflation may be due to either 1) oversupply of money within the economy 2) low demand for national securities of low risk and 3) the devaluation of currency, or a combination of all three. When the Treasury Bill side of the TED spread is not considered low risk, the TED spread loses some of its analytical capacity as the interest rate on Treasury bills is used as a stable low risk rate in comparison to the Interbank lending rates. If inflation is high and/or a Government is not well managed and insolvent, the value of the TED spread is diminished.
The TED spread is important because it is a simple and direct way to measure a number of things including how solvent the financial system's institutions i.e. banks are, and the availability of money i.e. liquidity within the economy. Since financial liquidity with low to average inflation is important for economic growth, a high TED spread of .5 percent or more is worth consideration in terms of investments, business development, economic performance and financial system functionality. During a financial crisis, such as that experienced within the U.S between 2007-2009, the TED spread went as high as 4.5% (bloomberg.com) indicating a very weak financial system, but a relatively stable Government.
A credit crisis includes a lack of credit availability, credit risk, low financial liquidity in an economy and carry over affects on the economy such as low mortgage originations, business loans, consumer loans and spending. Thus, a high TED spread indicator of 1-2% not only indicates weak macro-economic and financial market conditions (seekingalpha.com) but also micro-economic difficulties as they pertain to businesses and individuals.
To summarize, The TED spread is important in determining the possibility of credit default by financial institutions. Since several factors are built into the TED spread such as economic policy, government stability, inflation, market performance, and financial liquidity, the TED spread metric is useful in assessing the level of a credit crisis. Moreover, a credit crisis is likely to be measured by TED spread levels of 1% or higher assuming Treasury bills are in fact low risk government financial instruments.
Sources:
1. http://www.econbrowser.com/archives/2008/09/understanding_t.html
2. http://www.bloomberg.com/apps/quote?ticker=.TEDSP%3AIND
3. http://www.investorwords.com/5820/TED_spread.html
4. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aPuOuvIiLNho
5. http://seekingalpha.com/article/45987-understanding-the-ted-spread
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