By Eric Levine, CFC Financial Analyst
DECEMBER 3, 2012
Despite the number of potential speed bumps facing the economy, the markets have proven relatively resilient in 2012. But in times of uncertainty, it is useful to observe a variety of indicators in order to detect investor aversion to risk. Measures of volatility, capital flows and credit indices all reveal valuable insights about market sentiment. Because of the focus on equity markets, a violent stock market sell-off may be the most commonly watched fear indicator. But equity market declines often occur only after other indicators display negative trends, one of which is called the ?Ted spread.?
The three-month Ted spread is widely used to evaluate stress and the liquidity premium in short-term credit markets. The spread represents the difference between the three-month Libor rate (the rate at which commercial banks will lend U.S. dollars to each other for a three-month term) and the three-month U.S. Treasury bill yield (the rate at which investors will lend the U.S. government money for three months). Generally, when market sentiment is positive, financial institutions remain active in the interbank lending market, which maintains liquidity and keeps Libor rates low. But when market sentiment sours due to rising mortgage defaults or a potential sovereign default, market participants avoid the interbank lending market in favor of risk-free U.S. Treasury bills.
When the U.S. subprime mortgage market began to deteriorate in 2007, the magnitude of coming losses was unknown at the time. Because many commercial banks were exposed to mortgage debt, liquidity in the interbank lending market rapidly decreased. When financial institutions made loans to each other, they demanded higher rates of return due to the greater perceived risk. The reduced supply of credit and increased counterparty risk resulted in rising Libor rates. As bank funding costs increase, the higher costs are passed onto companies and consumers. Conversely, U.S. Treasury rates decreased as investor demand surged for safe haven assets, which permitted the U.S. government to borrow at lower rates. As a result, the three-month Ted spread widened considerably (see chart).
Over the past 12 years, the spread has averaged approximately 46 basis points (bps). The three-month Ted spread widened to an all-time high of 463 bps on October 10, 2008, following the collapse of Lehman Brothers. Due to unprecedented monetary easing by the Federal Reserve, European Central Bank and Bank of Japan, credit markets are awash with liquidity and the three-month Ted spread has recently narrowed to below-average levels, indicating that short-term funding markets are functioning properly.
Despite the number of potential speed bumps facing the economy, the markets have proven relatively resilient in 2012. But in times of uncertainty, it is useful to observe a variety of indicators in order to detect investor aversion to risk. Measures of volatility, capital flows and credit indices all reveal valuable insights about market sentiment. Because of the focus on equity markets, a violent stock market sell-off may be the most commonly watched fear indicator. But equity market declines often occur only after other indicators display negative trends, one of which is called the ?Ted spread.?
The three-month Ted spread is widely used to evaluate stress and the liquidity premium in short-term credit markets. The spread represents the difference between the three-month Libor rate (the rate at which commercial banks will lend U.S. dollars to each other for a three-month term) and the three-month U.S. Treasury bill yield (the rate at which investors will lend the U.S. government money for three months). Generally, when market sentiment is positive, financial institutions remain active in the interbank lending market, which maintains liquidity and keeps Libor rates low. But when market sentiment sours due to rising mortgage defaults or a potential sovereign default, market participants avoid the interbank lending market in favor of risk-free U.S. Treasury bills.
When the U.S. subprime mortgage market began to deteriorate in 2007, the magnitude of coming losses was unknown at the time. Because many commercial banks were exposed to mortgage debt, liquidity in the interbank lending market rapidly decreased. When financial institutions made loans to each other, they demanded higher rates of return due to the greater perceived risk. The reduced supply of credit and increased counterparty risk resulted in rising Libor rates. As bank funding costs increase, the higher costs are passed onto companies and consumers. Conversely, U.S. Treasury rates decreased as investor demand surged for safe haven assets, which permitted the U.S. government to borrow at lower rates. As a result, the three-month Ted spread widened considerably.
Over the past 12 years, the spread has averaged approximately 46 basis points (bps). The three-month Ted spread widened to an all-time high of 463 bps on October 10, 2008, following the collapse of Lehman Brothers. Due to unprecedented monetary easing by the Federal Reserve, European Central Bank and Bank of Japan, credit markets are awash with liquidity and the three-month Ted spread has recently narrowed to below-average levels, indicating that short-term funding markets are functioning properly.
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