TED Spread

Brian Milner wrote a great article regarding a possible indicator of the next financial crisis:

When will the next financial crisis hit?
by Brian Milner
September 28, 2007 at 6:56 PM EDT

As the U.S. dollar plumbed new depths yesterday against the euro and other major currencies and woes stemming from the U.S. mortgage mess continued to mount, the question in the marketplace was not if, but when the next major financial crisis would hit.

To which we would add: Will we have enough warning to take cover from the coming storm? And what form should that shelter take?

It's certain that we can't rely on central bankers or other government officials to clue us in. Most are still reassuring the public that all is right with the world and that there will be little economic spillover from the turmoil in the credit and currency markets.

Two days after Bank of Canada governor David Dodge said that the beleaguered credit market was getting back to normal, the central bank showed that the situation is anything but normal when it poured nearly $1-billion into the money markets to stabilize rates.

Dealing with a separate credit issue, the European Central Bank had to provide another €3.9-billion in emergency lending to meet the borrowing needs of banks this week, which means they couldn't get the cash at a reasonable rate from other banks.

That's a bad sign, because if anyone knows whether a financial institution is harbouring buckets of bad mortgages and other junk among its supposedly high-quality assets, it's another bank.

There's a way for investors to measure this lack of confidence called the TED spread, which has largely fallen into neglect in recent years.

Mention this gauge of financial system health to a bunch of MBA students today and they are apt to look perplexed. Some may even wonder why you're talking about bed linens.

All of which upsets Donald Coxe to no end.

“It was my guiding light,” says the esteemed author and global portfolio strategist with BMO Financial Group. He credits it with keeping his job on Wall Street 20 years ago when he used it to correctly forecast the 1987 market crash.

And Mr. Coxe insists that it still has considerable value today, despite vast changes in the global financial system in recent years.

The TED spread originally was the difference between interest rates on three-month futures contracts for U.S. Treasuries and Eurodollars with identical expiration months. The higher the spread between T-bills and Eurodollar rates the greater the perceived risk of defaults. U.S. Treasuries are considered risk free, while Eurodollar rates reflect the risk that lenders won't get paid back.

The Chicago Mercantile Exchange dropped T-bill futures this past summer due to lack of interest, leaving dedicated TED followers to rely on the less precise comparison of cash bills to Libor (London inter-bank offered rate). But it still does the forecasting job, as the summer's events proved.

Before the credit crunch hit with full force, the TED spread was at a benign level of about 0.40 per cent. But it soared to a high of 2.40 in August, a level not seen since 1987 crash, and stood at 2.15 the day of the big meltdown. It soon fell back to the 1.30 level, before creeping back up. Yesterday, it clocked in at close to 1.45. So it comes as no surprise to the shrinking band of TED fans that central banks would still be facing crunch issues.

“If the banks aren't sure a bank can meet a claim, they stop advancing money to each other and the TED spread jumps,” Mr. Coxe says. “So it tells you when it is that the banks don't trust each other.”

The world of financial liquidity has changed dramatically in just a few short years. Today, there are other huge pools of international capital denominated in yen and euros, which, collectively, dwarf the eurodollar market for seekers of short-term capital. Neither existed during the last major credit crisis nearly a decade ago. Another twist is the ability of traders to move millions electronically into other currencies at blinding speeds.

But for all that, if the good old TED spread widens again beyond, say, 1.75, it's a safe bet that the system has yet to repair itself.

The TED is not going to be the only alarm bell that goes off if things spiral out of control. Others to watch include the Japanese yen strengthening, gold prices skyrocketing and U.S. financial stocks plummeting. But if the TED takes off, it will definitely be time to lower the lifeboats.