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The Importance of TED
By Mel Miller

By Mel Miller, Chief Economist, First Affirmative Financial Network

I’m not referencing TED conferences or TED Talks here. The TED that many economists watch is the TED spread—the difference between interest rates on interbank loans and on short-term U.S. government debt. In this case, TED is an acronym formed from “T-Bill” and “ED”, the ticker symbol for the Eurodollar futures contract.

The TED spread is calculated by taking the three-month LIBOR (London-Interbank Offered Rate) minus the three-month interest rate on T-Bill issued by the U.S. Government expressed in basis points (each basis point is equal to one one-hundredth of a percentage point).

U.S. T-bills are considered “risk free”. The rate of interest paid on T-Bills is the borrowing rate for the U.S. Treasury. LIBOR is a daily reference rate reflecting the interest rates at which large banks can borrow unsecured funds (generally from each other), as compiled by the British Bankers Association. By comparing the borrowing costs of large banks (LIBOR) to the U.S. Treasury one can gain insight into the soundness of the financial sector.

The TED spread is a useful measure of credit risk. During periods of financial stress, the TED spread widens. Since it is reported on a daily basis, it is easy to spot trends. Assuming the reported rates are accurate (since some of the banks involved in the recent price-fixing scandal have agreed to pay huge fines this is probably a reasonable assumption), what does the current TED spread indicate?

The daily TED spread graph for the last 10 years highlights the stress during 2005-2009 period compared to the current spread of only 23 bps. It appears that the financial system today is much stronger than it has been in many years as measured by the TED spread.

Most variable rate commercial loans are LIBOR based; therefore a low LIBOR rate tends to encourage business expansion.

 

Posted: January 28, 2013