My son-in-law Ted's company has temporarily relocated him to Egypt this summer, and he's been sending home reports of his weekends spent kite surfing, viewing antiquities, and talking with ex-pats that have wonderful tales to relate. It might be more entertaining to include his reports here than to cover my intended topic, but that intended topic includes more sobering news on a different Ted.
I'm speaking of the TED spread. Those who have followed my articles over the years know that I began reporting on the widening TED spread a couple of years ago, when it began signaling some alarm about rising credit default risks. The TED spread is the spread between three-month treasuries (the "T" in "TED") and three-month Eurodollars (the "ED" in "TED"). Its traditional long-term range had been from about 20 to 50 basis points, with occasional blips down to about 18 and up to about 60. In June, 2007, it shot up to a many-years' high of almost 84 basis points before pulling back and then catapulting into what I believe was an all-time high in October, 2008 of almost 457 basis points.
Since equity markets tend to move in opposition to the TED spread and it had given us a heads-up that something was going wrong underneath the markets, we knew we should watch it. Although some argue that the TED spread is only one of many types of spreads that measure such risks and maybe isn't the best one to use at all times, it's an easily accessible spread to watch. Bloomberg offers quotes and charts, although the site is sometimes a bit cranky about allowing access to them.
In articles this last year, I had pointed out the spread's fall below that June, 2007 level as well as below several retests of that level in February and May, 2008. We needed to see the TED spread maintain consistent levels below the 80-basis point level and certainly below 100 basis points if we were to have any faith in further or sustained equity gains, I relayed to subscribers.
That's exactly what we've seen. As equities rallied, the TED spread not only stayed below those critical levels: it dived. So what's my problem now?
The TED spread has now sunk to test historical five-year lows. As I edit this article on the afternoon of September 4, the TED spread is 18.76 basis points, with the lowest closing low that I can find in the last five years at 17.50. The TED spread, supposedly measuring default risk, is very nearly at "the" five-year low.
Do we seriously believe that credit default risks are at five-year lows? And, even if we do, the TED spread is venturing into levels from which it tends to reverse higher, sometimes with disastrous effects on equities. For example, that 17.50 basis point closing low occurred in late February, 2005. Care to take a guess at what was about to happen to equity markets?
Because of width constraints on published charts and the clumsiness of the Bloomberg charts for the TED spread, I'm going to have to split the TED spread's chart into two sections, one from 2004 through early 2007 and the other from early 2007 into the present. On both charts, a light lavender horizontal line marks historical support that's currently being approached.
TED Spread from 2004-Early 2007:
TED Spread from Early 2007 through August 28:
The last time the TED spread approached this level is seen on the far left of the second chart (or far right of the first one), on February 16, 2007. My observations are that it wasn't the tests of these lows that predicted a rollover in the markets in 2007-2009 but rather a bounce from them that took the TED spread back up through 80 basis points and particularly through 100 basis points. However, even bounces inside the 20-50 range sometimes did often predict pullbacks, sometimes leading them by two or three weeks, giving lots of preparation time for those in long positions. The February 28, 2005 five-year low of 17.50 was followed by an interim high in the SPX of 1229.11, reached a week later on March 7, 2005. By April 20, 2005, the SPX had hit a low of 1136.15. However, it wasn't always easy to correlate a bounce in the TED spread with equity action as it sometimes led and sometimes coincided with a dip in the equity markets.
Sometimes the TED spread retested its low before it began a climb and that could happen this time, too, so I wouldn't consider the TED spread a good market timing tool. In Texas, we can have terrible summer storms that sometimes pack hail or conceal tornadoes. Storm or tornado sirens go off periodically in the areas that have such warning systems, with the horizon filled with green-tinged clouds. Hearing a siren doesn't mean we're going to be hit by a tornado, but it does mean that perhaps it's time to shut down electrical appliances that might be damaged by a lightning strike, park the car someplace where it won't sustain hail damage, and call all the children inside if they were playing outside. I feel the same way about the TED spread. I'm not hiding in a closet somewhere, and I'm still trading, but I'm sure being careful about not leaning to the long side too heavily.
Personally, I'd be leery of rally's sustainability if the TED spread were to mount any kind of significant rally off the being-tested support levels. However, it would be the rally that would take it back above the historical 20-50 range again that would signal that something more significant than a regular retracement might be occurring. We all hope that doesn't happen again.