A TED Spread Quandary

Bud in Virginia wants to know:

The TED spread is (thankfully) heading below [one], but I observe that both LIBOR and 3-month Treasuries are VERY low — does this dilute the good TED Spread news?

For those of you just joining us, I'll put some definitions at the very end of the post; if the above question makes sense already, forge ahead.

The interest rate on three-month Treasury bills serves as a benchmark for investors — it's called the "risk-free rate of return." Because no other borrower inspires the same level of confidence as the U.S. government, all other lending (including interbank borrowing) takes place at a higher interest rate than what you get for a three-month T-bill.

Recently, the TED Spread has decreased to below 1 percent, or 100 basis points. This is the lowest it has been since August 15, a sign to TED-watchers that the global capital markets have calmed down from record-breaking levels. (video) However, as Bud notes, this has taken place because both the LIBOR and the 3-month T-nill interest rate have declined.

Is this a bad thing?

Not necessarily. It is true that the T-bill interest rate has fallen to historic lows, which can be a good thing or a bad thing, depending on whom you ask. Ultra-low T-bill rates hurt money market funds, which typically buy up government bonds. In the past month, almost half have been reporting no return on their investment, making it difficult for them to compete for investors.

Likewise,LIBOR affects mutual funds that are set up to buy corporate bonds. Since companies typically offer bonds at a rate that's LIBOR plus, say, another percentage point, mutual funds stand to get lower interest on the bonds.

So by themselves, lower rates are bad for certain parts of the financial markets. However, it's good for almost everyone else. For the economy to be healthy, banks have to be stable. When the TED spread is low, it shows that the market considers banks nearly as stable as the U.S. government.

P.S.:Typically the 3-month LIBOR is a few tenths of a percent above the 3-month T-Bill rate. However, as this Wikipedia chart shows, we are living in unusual times. Keep an eye on the right side of our blog, where we bring you the very latest TED spread.


TED spread: The difference between the three-month LIBOR and the interest rate on three-month US Treasuries. It's an indicator of investor perceptions of credit risk in the global economy — the bigger the number, the more traders in the debt market are worried about banks failing. (video)

LIBOR (London Interbank Offered Rate): The interest rate that banks charge to lend each other money. This rate takes into account the probability that the borrowing bank will default. (video)
U.S. Treasury Bills (T-Bills): Short-term bonds issued by the federal government. They represent the most secure type of investment available to domestic lenders because of the general belief in the global debt market that the U.S. government is the world's most secure issuer of debt.

TED spread: The difference between the three-month LIBOR and the interest rate on three-month US Treasuries. It's an indicator of investor perceptions of credit risk in the global economy — the bigger the number, the more traders in the debt market are worried about banks failing. (video)

LIBOR (London Interbank Offered Rate): The interest rate that banks charge to lend each other money. This rate takes into account the probability that the borrowing bank will default. (video)
U.S. Treasury Bills (T-Bills): Short-term bonds issued by the federal government. They represent the most secure type of investment available to domestic lenders because of the general belief in the global debt market that the U.S. government is the world's most secure issuer of debt.

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