Earlier this week, I was talking to another trader. The inevitable "when will the rally stop" topic was raised. It was during that conversation that I remembered that many months had passed since I'd last used these pages to discuss the TED spread or the other under-the-market indicators that I often watch. Until early Friday, April 16, 2010, as this article was edited for publication, the indicator indices I watch--the quick-to-run TRAN and RLX, among them--were showing lots of froth but no signs of an imminent rollover. Friday morning's sharp pullback was being met by yet another attempt to run the markets higher. It was yet to be determined how the day would end, and there wasn't a lot on their charts that would prove interesting or predictive. The TED spread, however, was showing some interesting levels to watch.
I'll show the chart first and then we'll discuss some of the implications. I apologize beforehand for the quality of the chart, but this source is the only one I know that provides an up-to-date TED spread chart. This one was snapped Thursday, April 15. A quick check of early TED spread quotes shows that nothing material had changed as of early Friday morning.
Bloomberg Six-Month Line Chart of the TED Spread with Trendlines:
The annotations available on Bloomberg's chart are rudimentary at best, but let's examine what we're seeing on the chart after a little background on the TED spread. I've covered the TED spread in previous Trader's Corner articles, but the last time was September 4, 2009. That article is available in the archives as are previous ones.
The first thing to know about the TED spread is that it's considered by some to be a measure of credit default risk. Some traders or economists like watching this spread, and some, other spreads or swaps. I've heard that the TED spread's trustworthiness is questionable around the time of a lot of treasury auctions, for example. However, it's an easily understood spread, so that trumps other considerations for me. The second thing to know is that, although the TED spread shouldn't be considered a market-timing tool, equity markets have historically moved in opposition to the TED spread's moves.
With these few bits of knowledge in mind, we can already take a look at the short-term chart above and begin to make some assessments. We can see that in March, as the equity indices finally broke past the January highs, the TED spread was dropping into a new low. In fact, that low was the lowest low of any available on the Bloomberg's five-year charts. Before exploding higher during the worst of the credit crisis, the TED spread's traditional range was 20 to 50 basis points, with occasional dips down to about 18 and sprints up to about 60, but the TED spread eventually made it down to a low of 10.57 on 3/16/2010.
As the TED spread was hitting what I believe to be a five-year low in March, the chart suggests that it was forming the head of an inverse or reverse head-and-shoulders formation. The neckline is loosely drawn, with both my poor hand-eye coordination and Bloomberg's clunky tools contributing to the loosely-drawn nature of that neckline. We also see a descending trendline that intersects that neckline on the far right-hand side of the chart. Extended back, that trendline was formed beginning in mid-November, 2009. As this article was prepared, the TED spread had approached both levels of potential resistance.
A break above those trendlines might be a heads-up that underlying conditions are changing, while another sharp downturn beneath those trendlines might signal all-clear ahead to the ongoing rally, at least for the time being.
What exactly is the TED spread, now that we've discussed it at length? It's the spread between three-month treasures (the "T" in "TED") and three-month Eurodollars (the "ED" in "TED"). Our treasuries had been considered safer than the riskier Eurodollars, so the spread measured how risky the credit environment was considered to be.
As the TED spread dipped to those levels I believe to be all-time lows, I wondered if perceptions had changed. I wondered if the TED spread would provide as credible an assessment of default risk and as good a prognosticator of equity market behaviors as it had in the past. Worries about our debt and the specter of a possible failure of a treasury auction added to a cloudy picture, as did the looming problems in the Eurozone.
Will the TED spread be as important to watch in the future as it was in the past, when I first began watching it more than four years ago? I'm not sure. However, I do know one thing: if the TED spread breaks up through those trendlines and especially if it climbs back into its old 20-50 range and keeps going higher, I'll be paying attention. I'll make sure that all my income trades have insurance puts. In fact, I've already done so with most. Such signs might corroborate any equity weakness that preceded, accompanied or followed such action.
As I edited this article on the morning of Friday, April 16, 2010, the TED spread measured 15.32, down from a day's high of 16.23. It was back down to test the opening level on 4/14, a level that had also provided some temporary support from about 3/22 to 3/29 when it finally broke back below it again. Nothing had been decided yet as of Friday morning. Those who want to check the TED spread for themselves can do so by checking this Bloomberg site.