Back in June, we first got acquainted with the TED spread on these pages. It's time to check Ted's pulse again. Unfortunately, it's been racing lately.
A review might be useful for those who either missed the original article or have forgotten its major tenets. To put it simply, the TED spread measures default risk. It is calculated by comparing the difference in interest rates for three-month treasury bills, long considered as close to risk-free as investors could get, and the three-month LIBOR. The difference is expressed in basis points. A 0.2 percent difference in the rates would result in a TED spread of 20 basis points or 20 bps.
The original computation was made comparing the yield on a three-month U.S. treasure bill contract and the yield on a three-month eurodollars contract offered by the London InterBank Offered Rate (LIBOR). The "T" in "TED" came from the word "treasuries" and the "ED," from eurodollars. That eurodollars contract was considered to be impacted by the perceived credit risk of lending to commercial banks, so it was and still is considered the riskier of the two.
As the original article noted, the original computation was changed when the Chicago Mercantile Exchanged stopped offering futures on the T-bills. For more information about the TED spread's background and a discussion of the pros and cons of using the TED spread to measure default risk, you might consult the original article.
Some points from that article must be reiterated, however, before this discussion continues. Because of the way it's calculated, a rising TED spread means that default risk is considered to be rising while a declining one generally means that the risk is perceived to be declining. Equity markets do not like rising default risks, of course.
As that June article noted, a typical historical range for the TED spread is 10-50 basis points, but in August, 2007, it exploded out of that range, eventually ballooning above 200 basis points. How serious was such a rise? In a December 3, 2007 article for Seeking Alpha, Michael Panzer included the following historical chart:
Historical Chart of the TED Spread:
We should have been forewarned of what was coming, and some of us were. Those of you reading these pages certainly were. I've maintained updates on the TED spread ever since that May article on the Market Monitor, the live portion of the Option Investor website.
Panzer's point was that those comparing the situation to that experienced after the failure of the hedge fund Long-Term Capital Management might be underestimating the potential for damage. The TED spread, at least, showed conditions he called "more akin to the chaos that developed around the time of the 1987 stock market crash." That's chaos that we were to see playing out this last week. I began roughing out this article more than a week ago, intending it as a renewed warning, but now it will encapsulate some of what we've seen occur.
It's not enough to know that equity markets are probably acting badly in concert with spiking TED spread values. How high is "high"? We might imagine that any spike out of that typical 0.10-0.50 or 10-50 basis points range is bad for equity markets, but that wouldn't help us out much now even if we verified that were true. Since August, 2007, the TED spread has not returned to that previous historical range.
At the time of that May article, I'd found one article that quantified "bad" or "high" in the new aberrant range for the TED spreads. That was found in an article August 29 article by Bespoke Investment Group, "Understanding the TED Spread," in which they had reported mixed SPX performance after TED Spread spikes above 1.50 or 150 basis points. They had chosen 1.50 or 150 basis points for their benchmark as a high TED spread value.
My June article questioned that thesis. Weren't markets likely to be reacting to bad news already by the time that the TED spread spiked over 1.50 or 150 basis points? Wasn't there a way to pinpoint times when the TED spread was likely to rise again or perhaps, likely to turn down again so that traders could make appropriate what-if profit-protecting plans?
What I found was that since that December, 2007 spike high, the TED spread had been moving inside a wide descending channel. Approaches to support tended to be dangerous for equity bulls, especially those times when the TED spread steadied at that support and then bounced up through 0.90-1.00 again. This was well before the benchmark level studied by Bespoke Investment Group. Like that group, however, I also found mixed performance near my own benchmark high--the resistance level at the top of the descending channel. At times, equity markets had already begun to steady and had even begun bouncing as the TED spread approached the top of that channel; at other times, the declines were far from finished. However, several questions remained. The period was so aberrant that the touches of either trendline were few and the information therefore rendered anecdotal. There just wasn't enough information for any kind of scientific conclusion.
Equity bulls were wise to be alert to the potential for the TED spread to bounce, taking steps to protect their profits, while they could not count on resistance tests as being the time to buy the dips in equities. The possibility of a break through resistance always had to be considered, too. Chaotic conditions in financial markets could eventually result in even more aberrant behavior, as it was to do this week. Like many other observations or measures delving into the underpinnings of the market, the TED spread wasn't always a good market-timing tool, but it certainly served and continues to serve as a good warning tool.
For example, the TED spread stayed stubbornly at higher support as the Fannie/Freddie deals were worked out, all the while that market pundits spoke of the many benefits of this solution and the likely rapid improvement in credit and equity markets. The week of September 8, the TED spread began rising rapidly toward next potential horizontal resistance at 1.50, that same benchmark that Bespoke used to study SPX performance in relationship to the times the TED spread was considered high. As I had already believed, however, the equity markets did not wait for a TED spread move above 1.50 but were already reacting to the TED spread's test of horizontal support and the bounce from that support. They were to react more strongly as the TED spread broke to highs above those seen in the 1987 debacle, showing just how chaotic the markets were.
I apologize in advance for the production quality of the charts I'm including below, but I can find quotes for the TED spread only on Bloomberg, which doesn't allow for annotations or trendlines, so it was necessary to hand-drawn the trendlines and then scan the document in order to provide it.
Annotated Chart of the TED Spread and SPX:
The TED spread's moves after the Fannie/Freddie supposed solution showed us that tremendous risk remained in the market. By early this week, the TED spread had broken through the resistance of its descending channel. It was on its way up to levels that exceeded those seen in the 1987 debacle, pointing to the freezing up of the credit markets as the spread widened on increasing default fears.
Clearly, something had to be done. Something was, in the form of the rescue package announced by Treasury Secretary Paulson Friday morning. The necessity for something to be done was clear but what were the longer-term implications? What would happen as a result?
As of midday on Friday, September 19, the TED spread had pulled back sharply and had dropped to 2.46 as these words were typed. It had however, bounced from a low of 2.20, which just happened to be the December, 2007 high of 2.20. Is it possible that either that December high or else the former resistance line, now at about 1.70, will serve as support?
What can the TED spread tell us going into the future? I would advise watching
it carefully. A failure to break through 2.20 again would suggest that risk
remains inordinately high and that equity bulls might spiff up their
profit-protecting plans. I would again spiff it up if the TED spread should drop
to test the top trendline of that former channel in which it moved. A failure to
break back inside that channel or--worse--a bounce from it could indicate more
problems out there than
we want to see.