Nearly every day, a financial channel or news services pronounces the credit crunch behind us. Not so fast, others say. In his May 27 letter to fund investors, John P. Hussman, Ph.D. (www.hussmanfunds.com) warned that "credit default swaps blew out last week in a manner that we haven't seen since the week before the Bear Stearns debacle."
The TED Spread may help us determine when the crunch has eased or whether we need to start burying jars of money in our back yards. The simplest definition of the TED spread is that it's the difference in yield between U.S. treasuries and InterBank loan rates, the rates at which the major banks loan money to each other. Originally the calculation involved the spread between the yield (or futures' price, according to some sources) on a three-month U.S. treasury bill contract, from which the "T" was derived and that on a three-month Eurodollars contract, from which the "ED" was derived. Each had identical expiration rates, and the Eurodollars contract was that represented by the London InterBank Offered Rate (LIBOR).
What was being measured? Stated simply: risk. In TECHNICAL ANALYSIS EXPLAINED, Martin J. Pring says the TED spread "measures the relationship between ("high"-quality) T-bills and ("low"-quality) Eurodollars." Most consider the U.S. treasuries as close to risk free as investors can get. The rate for the Eurodollars futures contract, used in the original computation of the TED spread, is impacted by the perceived credit risk of lending to commercial banks.
If the spread between the two rates is relatively tight, the risk of default is believed to be decreasing. If the spread widens, the risk of default is believed to be increasing. If investors fear that risk is increasing, they'll start buying the safer U.S. treasuries, sending rates lower and widening the spread, especially if investors are concurrently shunning riskier corporate borrowers.
These days, the computation has been reformulated. When the Chicago Mercantile Exchange stopped offering futures on the T-bills, the TED spread was recalculated using the spread between the interest rate for three-month T-bills and the three-month LIBOR. The spread is calculated in basis points. Thus, if there's a 0.2 percent difference in the rates, the TED spread is 20 basis points or 20bps.
Some believe that a normal TED spread would likely be in the 10-50 basis points range. Last year it ballooned up to 250 basis points at one time, indicating that the risk of default was high. Since August 9, 2007, when it closed at 0.72 or 72 basis points, it has stayed consistently above those normal levels. The low since August 9, 2007 was recently achieved on May 27, when the TED spread closed at 0.7553 or 75.53 basis points.
In an August 29 article, "Understanding the TED Spread," Bespoke Investment Group warned that of mixed SPX performances after extreme TED Spread readings. For example, that article noted a spike on April 21, 1987 that resulted in lower values for the SPX a week and month later, but higher levels in three months. The spike on September 15, 1987, however, showed marked weakness remaining three months later.
I'm wondering if this article and others might not be looking at the TED spread the wrong way. I know, that's a bit of hubris, isn't it, for me to say so, especially when I freely confess that I'm just beginning to research the TED spread. However, bear with me as I explore. I was hired to represent the self-taught trader, the one exploring on his or her own, so let's explore.
Once the TED spread has spiked, I wonder, isn't the news already known? As the charts below will show, I'm wondering whether it might be better to look at the TED spread through contrarian eyeglasses. Waiting until it's over 1.5 might be a bit too late to discover that there's too much risk in the markets and move to protect equity longs.
If spikes above 1.5 are used as a measure, as Bespoke Investment Group defined a worrisome spike, the following chart from Bloomberg.com shows the TED spiking above that level in mid-August 2007, early November and again in early March this year. The SPX chart is immediately below. For ease in comparison, I've used the Bloomberg.com version of the SPX's chart, too, rather than my regular charts. Those don't provide a quote for the TED spread. Also, note that these charts were snapped a week ago and do not include current prices.
One-Year TED Spread Chart and SPX chart from Bloomberg.com:
Although I wasn't able to draw trendlines on these charts, a couple of points proved worth noting. A descending trendline can be drawn across the spike highs in the TED spread. A similar and parallel one can be drawn beneath the spike lows from August 27, January 27, and February 12 & 13. If one studies the spike highs as they're hitting the trendline and then compares SPX behavior, it's clear that the spike highs are either occurring well in advance of the SPX price highs . . . or, they're occurring as the SPX is already beginning to recover. That would go along with my theory that once the TED spread had spiked, the news was already known and markets had already reacted. Perhaps that was too late to think about protecting equity longs?
Now let's look at this from a contrarian viewpoint. To do so, study the places where the TED spread is coming down to hit the imaginary lower trendline, parallel to that descending top one. Note what happens to the SPX when the TED spread hits that lower trendline and then moves up through 1.0 again. For example, on October 15, 2007, the TED spread hit the lower trendline and by October 16, it had closed just under 1.00. On October 17, it closed at 1.20.
By then, SPX prices were already moving down some from their October 11 intraday high, but despite a sharp drop October 19, prices were to bounce again into their October 31 lower high. On October 30, however, the TED spread had again approached 1.00, testing it and closing just beneath it. Essentially, the 0.90-1.00-ish support was beginning to hold and the TED spread was in the process of completing a higher low while the SPX was completing its lower high. Then the SPX plunged as the TED spread spiked.
However, let's examine one case that refutes my whole theory. Got to be fair, right? The next test of the TED spread's upper trendline was December 12. The SPX was indeed beginning the process that would result in the long slide lower into the January low. A TED spread high and not a lower trendline support test occurred as SPX prices topped.
The refutation of my theory lasted into the next test of the TED spread's lower trendline was in January. By that time, the SPX had dived below its November low and was trying to consolidate. It was forming a triangle with an apex near that November low. The TED spread had dropped and, on January 16, 2008, the TED spread was again hitting that lower trendline. That's when the refutation of my theory stopped. As the TED spread dropped, perhaps hitting newly established support, the SPX dropped, too, closing at a closing low not seen since the previous March, when the credit woes first hit. However, by the January 18, the TED spread had again closed above 1.00, and the SPX was on its way into its January low.
By February 12, the TED spread had again hit that supporting trendline, where it sat through the 14th. By the 26th, it was testing 1.00 and on the 27th, it closed above 1.00 again. The SPX hit a lower high that day and then started down into its long slide into its March low as the TED spread spiked into its March high. From March 19-21, the TED spread was challenging that upper trendline again, closing above 2.00.
While the TED spread was hitting possible resistance, however, what was happening with the SPX? It had already hit its March intraday low on March 17. March 18, it gained sharply. March 19, it had reversed much of the previous day's gains. March 20, it reversed almost all the previous day's losses. Then, as the TED spread rolled down from resistance, it broke out again. By the time the TED spread had spiked that high, the news was already known and the SPX had begun stabilizing and then recovering.
As the Bespoke group warned, the evidence is mixed, but in my opinion, we should at least put on our contrarian glasses every now and then when viewing the TED spread. We should first keep in mind that these few comparisons made on these pages can be nothing more than anecdotal evidence. They're not conclusive and do not constitute any kind of definitive or analytical study.
We should acknowledge that the TED spread is not an exact market timing tool. However, with those caveats, perhaps when that lower trendline is being approached, as it is being lately, perhaps investors are taking on a bit too much risk for the climate. Perhaps they're doing a bit more dumping of U.S. treasuries and taking on of riskier securities, narrowing the spreads below more than is optimal for the market environment over the last year.
What about the possibility that the TED spread will eventually return to its previous range? As the previous text explains and the following chart shows, the TED spread remains well above that previous range.
Five-Year Chart of the TED Spread, Chart from Bloomberg.com:
Although it's always possible that the TED spread will return to its previous range, this climate dictates that we acknowledge the possibility of another bounce through that wide descending channel that can be drawn since last year and make appropriate plans. Those plans would acknowledge perhaps that there's too much risk in the market than is optimal in the current climate. Plans to protect bullish profits could be made, as I think should be done. As I revise this article on Friday, June 06, 2008, the TED spread had climbed to 0.87, still below the 0.90-1.00 that perhaps begins to signal some trouble, but climbing from its May approach to the supporting trendline.
What about when the TED spread is hitting the top trendline? That's a bit more problematic. Although equity markets had twice this last year already begun a recovery attempt by the time that top trendline was hit, that's not always true. In December, the TED spread was hitting the top trendline concurrently with a market top.
Also, due to the nature of the current worries in the market and the risks some still believe are looming due to the credit crunch and liquidity problems, I don't think we can always assume that the top trendline won't ever be broken. Still, if equity markets have already rolled over concurrently with a spike in the TED spread that carries it up toward that possible resistance again, those in bearish positions should also be aware of their risks as the TED spread approaches the top trendline again, if it does, and make plans to moderate that risk.
Unfortunately, my charting service does not provide quotes for the TED spread, and I can't find a historical source that goes back longer than five years. That means I can't conduct a more thorough study than has been done so far. Perhaps these last several years have produced actions that are so out of whack with norms that these observations will prove useless in the future.
However, by whatever method the TED spread is calculated and whether or not its
performance is mixed, investors should be familiar with the term and should keep
it on their radar screens. Bloomberg offers a free quote and charts, available
this link with the symbol TEDSP:IND. If there's a perception of increased
risk of defaults, we should probably know about that, don't you think?