What Is the TED Spread?
Let me explain what the TED Spread is directly to you: it's the difference between the three-month Treasury bill rate and the three-month LIBOR rate based in U.S. dollars. In simpler terms, you're looking at the gap between the interest rate on short-term U.S. government debt and the rate on interbank loans. TED stands for Treasury-EuroDollar rate, and that's the core of it.
Key Takeaways
- The TED Spread is the difference between the three-month LIBOR and the three-month Treasury bill rate.
- It's commonly used as a measure of credit risk, since U.S. Treasury bills are viewed as risk-free.
- The spread often widens in economic crises as default risk grows, and it narrows when the economy stabilizes and defaults become less likely.
Understanding the TED Spread
You should know that the TED Spread started as the price difference between three-month futures contracts on U.S. Treasuries and three-month Eurodollar contracts with the same expiration. But after the Chicago Mercantile Exchange dropped Treasury bill futures following the 1987 stock market crash, we adjusted it. Now, I calculate it as the difference between the interest rate banks lend to each other over three months and the rate the government borrows at for the same period.
This spread serves as an indicator of credit risk. U.S. T-bills are considered risk-free, representing the ultra-safe bet of the U.S. government's creditworthiness. On the other hand, LIBOR is a dollar-denominated measure reflecting the credit ratings of corporate borrowers or the risk large international banks take when lending to each other. By comparing the risk-free rate to another interest rate, you can gauge the perceived risk difference. So, think of the TED Spread as the gap between what investors demand from the government for short-term Treasuries and what they charge large banks.
Important Update on LIBOR
Here's something critical: According to the Federal Reserve's announcement on November 30, 2020, banks must stop using LIBOR in new contracts by the end of 2021. The Intercontinental Exchange, which handles LIBOR, will cease publishing one-week and two-month LIBOR after December 31, 2021. All existing LIBOR contracts need to be resolved by June 30, 2023.
How the TED Spread Behaves
As the TED Spread increases, it signals rising default risk on interbank loans. Lenders demand higher interest rates or opt for lower returns on safe T-bills. In essence, if banks pose higher liquidity or solvency risks, lenders require more on loans to other banks compared to government loans. When the spread decreases, default risk is seen as dropping, prompting investors to sell T-bills and shift to the stock market for better returns.
Calculation and Example of the TED Spread
The calculation is straightforward: TED Spread equals the three-month LIBOR minus the three-month T-bill rate. You can let the St. Louis Fed handle the charting for you—it's easier that way.
We usually express the spread in basis points (bps). For instance, if the T-bill rate is 1.43% and LIBOR is 1.79%, the TED Spread is 36 bps. It typically stays between 10 and 50 bps but can surge during economic crises. Take the 2008 Lehman Brothers collapse: the spread hit 450 bps. An economic downturn makes banks wary of others' solvency, restricting interbank lending, widening the spread, and reducing credit for individuals and corporations.
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