The TED spread is the difference between the three-month commercial interbank lending rate (LIBOR) and the three-month US Treasury bill yield. LIBOR is a rate that is used to measure the cost of bank-to-bank lending and borrowing. The US Treasury bill yield is generally interpreted as the de facto risk free rate. So the difference between the two indicates whether a bank would prefer to lend to another bank (a risky entity), or to invest in a risk free security, which depends on how risk averse the banks are feeling on any given day.
Let’s take a look at the definition of the TED spread:
TED = LIBOR – TBILL
In times of crisis, banks would prefer to invest in Treasury bills, which would drive their their yields down. At the same time, banks would stop lending to one another, which would drive LIBOR up. Both, in turn, would cause the TED spread to increase, indicating that banks are feel particularly risk-averse during a crisis.
For example, let’s say that Bank A desperately needed to borrow some funds in a crisis (to fulfill their reserve requirements, for example), but they could not find a lender. Depending on how badly they needed the money, and how few options they had, they would continuously offer to increase the borrowing rate, until they got the money they needed. They would be constantly bidding LIBOR up. During that same crisis, Treasury bill yields would decreasing because other banks are putting their money there, instead of giving it to Bank A .
This is exactly what happened during the Fall of 2008.
Image source: Wikipedia
As you can see, starting around mid-September until around mid-October, LIBOR increased, and the T-bill yields decreased, causing the TED spread to widen. This indicated that because banks were uncertain about the events to unfold in the three months following September 2008, they preferred to put their money into risk free instruments, rather than lend to each other. This was the infamous ‘credit crunch’; in other words, credit dried up.
The TED spread is thus, like the equity market risk premium, another measure of market risk aversion. However, unlike the equity market risk premium, the TED spread is perhaps more accurately a measure of the market liquidity risk premium, since the spread increases when loan availability (liquidity) decreases.
Given the situation in Europe, one would think that risk aversion levels would be increasing, liquidity decreasing, and the TED spread widening. But, as Professor James Hamilton over at Econbrowser says:
World Bank President Robert Zoellick thinks that this summer is looking like an eerie echo of the months leading up to the Lehman bankruptcy in September 2008, this time with European sovereign debt taking the role of mortgage-backed securities as the asset no longer viewed as safe. But one important difference is that this time the banks are swimming in liquidity. A TED spread at 40 basis points does not look remotely like an echo of early 2008.
I guess we’ll find out how much difference that makes. [link]
As he points out, bank liquidity is high largely because of the ECB’s Long-Term Refinancing Operation. Below is the TED spread over the last one year from Bloomberg, and it is low at 0.4%:
Because of the speed at which this crisis has unfolded, and the measures taken by the ECB to keep things in check, it has resulted in somewhat less-panicked investors, leading to…
…not a bank run but what PIMCO’s Mohamed El-Erian calls a slower “jog” as depositors take their money out of banks in Greece and Spain. Much of Europe is already in a recession, and significant financial disruptions there would hardly leave the U.S. or emerging economies unscathed. [link]
It almost seems like European dilly-dallying has given investors the time they need to react rationally to the unfolding situation, and exercise enough damage control before the fact, rather than hastily retreating after the fact. Perhaps this is one of those rare advantages of moving slowly in a situation such as this one.