TED spread and LIBOR

Markets are a discounting mechanism that take all available information into account. Prices will rise or fall in anticipation of news, and prices can react in a variety of ways to the news. The current financial crisis talked about so much in the news has created an extreme in volatility. Panic leads to selling. Hope of a bailout leads to buying. These two, panic and hope, are swinging the market violently. This is good for day traders but unsettling to say the least for most investors.

The TED spread is the difference between the interest rates on inter-bank loans and T-Bills. TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract. The TED spread is calculated as the difference between the three-month T-bill interest rate and the three month Eurodollars contract as represented by the London Inter Bank Offered Rate (LIBOR). The TED spread is a measure of liquidity. As such, the TED spread is an indicator of perceived credit risk in the general economy. The TED spread and LIBOR rates can be viewed as indicators quantifying the confidence banks have in lending to each other and the financial system as a whole. In calm markets the LIBOR is about 1/2% above the yield on the US debt.

The chart below shows how since August when the TED spread was at 1% it has spiked up to 3%. This is associated with the recent credit crisis and bank failures and a massive effort by the government to inject liquidity into the system. It shows that the confidence banks once had in lending to each other has dried up and that now banks are hording cash. The $700B financial rescue plan expected to be voted on tomorrow should show a significant change in the chart below should it be passed. We will just have to wait and see. Click on chart to enlarge.