Friday, January 22, 2016

Don't forget the TED spread

This blog has paid a lot of attention to swap spreads over the years, in the belief that they are good coincident and leading indicators of systemic risk and economic and financial market health. Swap spreads have been very low of late, despite the turmoil in the oil patch, which has sent spreads on high-yield energy-related debt to levels not seen since the height of the 2008 financial panic. I think that means that the problems in the oil patch are not likely to spread to other areas, in the way that problems with mortgage-backed securities spread to the global economy in 2008. Why? Because swap spreads tell us that liquidity is abundant (thanks to QE) and the financial markets are thus able to fulfill two of their primary roles, which is to spread risk around and, through the magic of markets, find prices that match sellers to buyers, and that balance the supply of and the demand for commodities such as oil. Markets can almost always solve problems if left to their own devices, and if central banks respond to crises by providing needed liquidity.

A related indicator, lost in the QE shuffle of the past 7 years, is the TED spread, which stands for the difference between the yield on 3-mo T-bills and 3-mo Libor (T-bills/Euro Dollars). It is a direct measure of the premium that investors demand for accepting the risk of loaning money to a bank rather than to the U.S. Treasury. 

As the chart above shows, that spread soared to more than 300 bps at the height of the 2008 financial crisis, an indication that the world was deathly afraid that more banks would collapse in the wake of the Lehman failure. The TED spread also soared in late 1987, as the S.E. Asian currency crisis blossomed and entire banking systems overseas were threatened. The spread rose for years prior to the 2001 recession, accurately signaling developing problems. In contrast, the current level of the TED spread, 34 bps, is about what it equals during periods of relative calm.

The chart above shows the evolution of the TED spread (the bottom half of the chart) and its components (top half). What it also shows is that the Fed's efforts to raise money market rates through its IOER reverse repo program are working. 

This last chart shows just the yield on 3-mo T-bills, often referred to as the bedrock risk-free rate for the entire world. That this rate has risen from zero to 30 bps against the backdrop of a global financial panic in recent weeks is notable, to say the least. If global conditions were truly calamitous, the Fed's efforts to raise short-term rates arguably would have proved futile, as there would have been an overwhelming demand for the safety of 3-mo T-bills. [Chart corrected from initial publication to show a closing yield of 0.3% rather than 0.24%.]

Bottom line, the underpinnings of financial markets look reasonably solid, and that offers the promise that the turmoil in the oil patch will be resolved without plunging the world into another 2008-style crisis.


Tom L said...

Thank you Scott. Enjoy the slopes and sun!

Benjamin Cole said...

Well, I still wonder if the Fed's policy of slow monetary asphyxiation will work. This strikes me as a perfect time to gun the presses and shoot for prosperity.

There is a serious issue that the supply of housing is restricted in America due to local property zoning. But that remains outside the ken of the Fed. And a non-PC topic!

Benjamin Cole said...

PS ...why the 3-month Tbill spike?

Related to the Fed hike on IOER?

William McKibbin said...

I suspect the Fed's tacit intervention into the fracking industry with bridge financing (via its Wall Street proxies) will have the effect of settling down the markets, especially with the rumor of Congress considering an embargo tax on oil imports -- I'm not sure what the side effects of an embargo tax on oil might be, but some kind of retaliation by OPEC will no doubt follow -- but again, the Fed's intervention into the fracking industry is shoring up the "oil patch" quite well -- should be smoother sailing in the markets the next few months.

Johnny Bee Dawg said...

T-Bills spikes have always preceded Fed rate hikes in the modern era. The Fed has jawboned the market into moving before they act. Markets tell them when its OK to move. More coming. Each hike will start being less punative to stock market, IMO, as long as Fed stays super accommodative. Just like market pouted in a taper tantrum, it will finally figure this one out, too.

Andrew Ross said...

The IOER reverse repo is working very well for big banks, but it's not benefited main street.
If anything, it has insulated banks from the economy.

Benjamin Cole said...

The reverse repo program---artificially raising short-term interest rates?
What is the upside in that?

marcusbalbus said...

still buying apple grannis? booya!

Benjamin Cole said...

Some are now positing that the expected return on cash will soon top expected return on assets. A 2008 replay.

The Fed appears very reckless and imprudent in its monetary policy.

Can we get that non-business priented academic Yellen out of the Fed, and a pro-growth, pro-business type in?