Wednesday, August 24, 2011

TED Spread: 3-month LIBOR greater than 2 year treasury yield!

TED Spread revisited as the yield of 3-month LIBOR and the 2-year US treasury invert!

What is the TED Spread? This from The Political Commentator back in July:

"As a barometer of the "flight to quality" of funds around the world, the TED Spread is a gauge of investor comfort, panic and the willingness of banks to lend money to each other.

The Ted Spread is the difference as quoted in U.S. dollars, between the 3-month treasury bill and the 3-month LIBOR rate.

The value of the TED Spread during "normal" times is typically .10 to .50 basis points (currently .24). In other words if the 3-month treasury was 1.1% then the 3-month LIBOR rate would be anywhere from 1.2% to 1.6% (current 3-month rates are much lower).

During the height of the 2008 financial crisis, the TED Spread grew to as large as 465 basis points! This meant that using the same hypothetical 1.1% 3-month treasury bill rate, the 3-month LIBOR would have been 5.75%..."

Flash forward and instead of the 3-month US treasury bill look instead at the 2-year US treasury note!

Under normal market conditions the cost, or yield, demanded by one European bank from another European bank for overnight lending (LIBOR) would be lower than the yield demanded by an investor in a 2-year US treasury note.

This of course assumes that they were considered relatively like quality investments.

A two-year US treasury note has greater market or interest rate risk and one could make an argument for greater credit risk going out 2 years, particularly now.

Over time, this has been the typical risk-reward relationship as you move out on the yield curve to longer maturities (upward sloping yield curve).

The TED Spread using 3-month LIBOR and the 2-year US treasury

3-month US treasury: .01%

2-year US treasury note yield: .21%

3-month LIBOR: .29%

The TED Spread is .08 using the 2-year (.29 - .21), when one might think the spread should be negative (or that the 2-year treasury was yielding more than the 3-month LIBOR).

So what does this mean?

The TED Spread is currently no larger than its historical range, so does this inversion between 3-month LIBOR and the 2-year US treasury signal recession, European credit crunch Part 2 or simply a flight to quality in the US sovereign debt market?

It's a wait and see!

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