Thursday, February 21, 2008

The TED Spread

The TED Spread is the difference between U.S. Treasury bill yields and yields for Euro deposit contracts of the same maturity as represented by LIBOR. The name derives from "T-Bill" and "ED” (the ticker symbol for the Eurodollar futures contract). The TED spread is used as a measure of investor confidence and is considered to be a leading indicator of stock market performance.

Originally the TED spread was the difference between the interest rate for the three month U.S. Treasuries is contract and three month Eurodollars contract. Since the Chicago Mercantile Exchange (CME) dropped the T-bill futures, the TED spread is now calculated as the difference between the T-bill interest rate and LIBOR.

The TED spread acts as a measure of credit risk and represents the flow of dollars into and out of the U.S. An increasing TED spread indicates increasing risk, while a decreasing spread signifies decreasing risk. A sudden widening of the TED spread demonstrates a flight to quality, and is indicative of a market under stress.

A recent chart of the TED spread demonstrates the spikes above the 1.5 level which has historically preceded some declines in the stock market. The sudden increase and extreme volatility of the spread shows a market under stress from the subprime credit issues. The spike in the TED spread in late 2007 preceded the January market slide; staging a scenario where the spread acted as a leading indicator to the decline of the stock market.

A chart of VIX during the same period shows strong volatility at the readings bounced between 16 and 31, but was less effective in acting as a leading indicator for the market decline. VIX tended to track rather than lead the market. Once example is the rise of VIX from 18 to 31 in early January which is virtually in lock-step with the market drop.

Does the Ted spread always act as a leading indicator of an impending market decline if the level rises above 1.5; according to Bespoke the historical record does not demonstrate this strong correlation. It is more important to focus on the volatility and direction of the TED spread as a leading indicator. Huge volatility and a rapid rise to a high level is a more solid leading indicator of credit stress that would lead to a stock market drop than slow changes in the TED spread.

When evaluating market conditions, it makes sense to pay attention to the TED spread. Many times it serves as a much more effective leading alarm than VIX in revealing the potential for downside risk.

On the positive side, the recent decrease of the TED spread to below one is indicative of improving credit conditions and is a green light for stock investors. However with credit conditions deteriorating in other debt sectors (Munis, auto, credit card); investors should watch for rapid changes in the spread which would serve as a warning flag of possible further stock market declines in 2008.