Farewell, TED… See you again?

I’ve written a few times about the TED Spread (e.g.,  here), that historically reliable indicator of systemic risk.  I’ve updated the chart:

The TED Spread: 3-month T-bill vs. 3-month Eurodollard Deposit (LIBOR)

The TED Spread: 3-month T-bill vs. 3-month Eurodollar Deposit (LIBOR)

The TED spread has now returned to about 50 basis points, levels I would associate with the “normalcy” that preceded the Panic of 2008.  There was always a question as to whether the TED would return to such low levels or would forever reflect some kind of unforeseen-event-risk (the “fat tail” of the probability curve that’s been much discussed in the trade).  Cynics might argue that the TED returning to such low levels shows that market participants have learned nothing from the financial system’s upheaval.  I prefer to see this as a recognition that the U.S. government does have the will and power to prevent a systemic meltdown (obviously, there are costs involved).

The TED’s narrowing is good news for the economy as it typically leads other credit spreads and allows the Fed to once again be in control of short-term interest rates.  In this low rate environment, this translates to lower interest rates for borrowers, starting with adjustable rate mortgages tied to LIBOR.  Corporate borrowers using short-term instruments are also direct beneficiaries.  Those who borrow at longer term rates have a mixed picture — higher Treasury yields but narrowing credit spreads — by and large, the credit spread factor is now the more important ingredient so those borrowers are beneficiaries. 

I’ve now been following the TED Spread for 23 years.  For many, many years, the wisdom was that “the TED is dead,” forever locked in a narrow range (call it 30 to 50  basis points).  I, like many others, simply stopped watching this important intermarket relationship.  Has the TED gone back to this dormant state?  I’m not so sure.  For one, the TED has historically been impacted by the general interest rate level — that is, the higher the interest rate environment, the greater the TED spread, even given the same perceived credit risk.  Given the inflationary forces that the monetary and fiscal stimulus may unleash, I can easily envision a scenario where the TED widens on the back of Fed tightening.  Moreover, our ability to successfully fend off a financial meltdown was partly due to the flexibility available in an environment with relatively manageable levels of government debt and limited inflation.  Our ability to fix an unforeseen future crisis may be constrained by the costs of the policies we’ve employed to address the current situation.  Given the advance warning the the spread signaled in 2007, I’ve made a promise to myself to keep an eye on the TED Spread for the rest of my career.  I wish I could say, “goodbye” to TED, but fear it may really just be, “au revoir.”

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