Question: Where Should TED Be?

Michael Carasik asks:

Should the "TED Spread" really be under 1, or is that just where it was before the collapse happened? In other words, is it true that the closer the TED Spread gets to 0, the closer to Utopia we are, or is this a number that is, say, 1.5 or even 2 in a healthy economy?

Laura and I often say that we'd like to see the TED Spread below 1 before we can say we're in a truly healthy economy. so, Michael asks the good question: is that just an arbitrary number?

Let's break apart the TED:

T refers to the current interest rate of T-bills, the short-term bonds that investors can buy from the US government. Basically, it means the interest rate the government will pay you to lend them money for 3 months.

ED refers to EuroDollars—a term for US dollars lent or borrowed by banks outside of the US. Currently, it specifically refers to the interest rate set by the British Bankers Association for bank-to-bank loans for 3 months (known as 3 month LIBOR). That's how much interest a bank will pay you to lend them money for 3 months.

The Spread is the distance between the T and the ED.

T is as close to risk-free lending as possible—you are lending to the US government. So, that rate is considered the floor—nothing is lower than that. Because nothing can be less risky. (Actually, to be technical, some tax-free municipal bonds are often lower because T-Bills are taxable).

The ED should be pretty close to the T. Any distance between the T and the ED rate is the extra premium investors are demanding for the risk of lending money to a bank. It represents the investors' collective fear that some of the biggest banks in the world might go bankrupt in the next 3 months.

For most recent history, the T and the ED have been very close together. It is hard to imagine them being much farther apart than 0.5% in any normal time. There shouldn't be a whole lot of worry that major banks will go bankrupt.

So, Michael, if you see 1 or 1.5, that shows that investors are still quite concerned. They're not as worried as they were when the spread was above 4. But they're still pretty anxious.

So, yes, I'd say that until that number is well under 1, we're in abnormally anxious times.

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