The TED spread gives us a view on the credit markets or the cost of money, and the reason it is called the TED spread is because it was originally established as a measure of the difference between interest rates on 3 month T bills and the 3 month Eurodollar contracts with identical expiration months. The T comes from the T of T-bills, whilst the ED is the ticker symbol for the Eurodollar futures contract on the CME, so the two were simply joined together to come up with the TED.
Today, the TED spread measures the difference between the interest rates on a 3 month T-Bill measured against the 3 month LIBOR rate. LIBOR is the London Interbank Offered Rate. It is a very simple calculation. For example, if the LIBOR rate is 2.75% and the equivalent rate on the T-bill is 1.75%, then the TED spread is the difference between the two, in other words 1%.
This is normally expressed in basis points so the difference is simply multiplied by 100, However, charts do vary. Some record in this format, whilst others record the spread in the true percentage difference.
The question of course is - what does the TED spread chart tell us?
Despite the financial crisis of the last few years T-bills are universally perceived as risk free, whilst LIBOR on the other hand reflects the interest rates that banks are prepared to lend money to one another. Wholesale lending if you like.
The TED spread therefore reflects the difference between the rates at which lenders are prepared to lend money to the US government and what banks are likely to charge each other.
So, it is an excellent proxy for credit risk.
Typically, the spread is represented in basis points so a 0.25 percentage difference would be appear as a 25 basis point spread; a 0.50 percentage difference would appear as a 50 basis point spread and so on. On the chart the spread will be appear as a simple number somewhere between zero and 500. But as I said earlier, this does vary from one chart to another.
The highest number ever recorded was at 463 in mid 2008 when the financial crisis was at its peak. This meant that at this point there would have been a 4.63% difference in interest rates between the Libor rate and the US 3 month T-bills.
But, how do we read the TED spread chart?
Put simply, as the TED index rises it is denoting a widening spread, which signals increasing concerns about credit risk for two reasons. First, it could be as a result of banks becoming increasingly nervous about lending to one another. Or second, it signals that investors are flocking to safe haven investments such as US treasuries. In other words, LIBOR rates are rising and the yield on Treasuries is falling.
A TED spread that is falling denotes a narrowing of the spread and tells us that credit markets are functioning. In this case, the LIBOR rate is falling, so risk is considered to be low in the wholesale banking market, and in addition, investors are more willing to accept risk by selling T-Bills, with a consequent rise in yields.
If the spread is widening and the index on the chart is moving higher, we can assume that the market is not in the mood for risk. In order words it is a risk off environment. Money flow is likely to be into safe haven assets and safe haven currencies and away from risk assets such as equities, commodities and risk currencies.
Investors are moving into T-Bills as they believe stock markets are likely to fall, with the spread increasing and the index rising.
A widening spread can also be an indication that the credit markets are not functioning correctly, and can therefore be a potential sign of economic contraction, because if people cannot obtain credit then the economy is unlikely to expand.
What if the TED spread is falling or the spread is decreasing with the index falling? In this case it tells us the opposite of the above.
There is a lower risk of default, so wholesale interest rates between banks will be lower,
investors are selling bonds and T-Bills as they believe they will obtain a better return in the stock market and from higher risk asset classes. Finally, with credit markets working normally, then we can expect to see economic expansion as a result. At first glance this can appear a complex index to follow. In reality it isn’t, and whilst it is not one you are going to watch every day, you do need to consult it periodically to check for any clues or signals of what is going on in the money markets. And, in particular, watch for any signs of changes in risk appetite and market sentiment.
Until recently it was relatively easy to find a chart for the TED spread. It used to be freely available at Bloomberg as part of the charting options. However, Bloomberg recently decided to withdraw the chart of this index, so the place to go now is to head over to
http://www.stockcharts.com and enter the ticker symbol $TED which will bring up the respective chart.
As I said earlier, this is not a chart to watch on an intra day basis, but rather on a daily or weekly basis. This will then give you an alternative perspective on risk and risk appetite as measured using the ever changing spread in this relationship.
Just like the VIX in the previous chapter, which is the premier fear indicator, the TED index works inversely with equity markets. In other words, if equity markets are rising then the TED index will be falling, and conversely when stock markets are falling, then the TED index will start to rise. Anything about 100 or 1% will set the alarm bells clanging, while a move below 50 or 0.5% is where markets are complacent and risk appetite it rising.
You can find an alternative to the TED spread index by visiting the Federal Reserve Bank of St Louis, and creating your own chart, which is shown below. I show you how to do this in the next section when we look at the TIPS spread.
Fig 11.10 TED Spread - Courtesy of the Federal Reserve Bank of St Louis
Another important secondary index is the TIPS spread. Like the TED spread this one is not really an index at all, but a measure of the variation between two interest rates, but I’ve included it here, so that the TED and TIPS sit together in the same place within the book.
The TIPS spread is a little more difficult to construct, as we have to create the chart ourselves using two different instruments, but it is yet another important economic indicator which this time tells us about inflation.
Like the TED index, this is not a chart we look at constantly, but simply one to refer to now and again, for a longer term perspective on the economy and the prospects for inflation.
The good news is that it is very simple to understand as the chart is a simple comparison between the yield of TIPS which are Treasury Inflation Protection Securities, hence the acronym TIPS, and our old friend the conventional US Treasury with the same maturity date.
The reason that the TIPS spread is so important is that the payments for TIPS adjust for
inflation, whereas the simple Treasury note or bill does not. This gives us a direct and simple view on the prospects for future inflation.
The TIPS spread is one of the few market based measures of inflation expectation, and the spread is therefore the difference between a normal bond, usually the ten year Treasury bond and an inflation index bond of the same maturity. Moreover, the principle reason for watching the TIPS is that inflation index bonds are benchmarked using the CPI, the Consumer Prices Index, a term I will explain in the next section of the book.
In plain English, the wider the spread between the two yields then the higher investors‘
expectations are of inflation, whilst the narrower the spread between the two yields then the lower investors’ expectations. If the spread is widening, traders and investors are expecting inflation, and conversely if the spread is narrowing then inflation expectations are declining.
This is another key measure used by central banks to gauge the current inflationary pressures in the economy and whether to manage this through the interest rate mechanism.
I hope, by now, you are beginning to see how powerful related markets and analysis of these relationships can be in providing a fully formed view of the market. Perhaps, you can also begin to see why so many forex traders fail. However, I do understand that some of this can seem overwhelming when you first start, but you must remember that some of these charts and indices are only checked occasionally, not every minute of the day.
Furthermore, whilst there appears to be a lot to do each day, once you have a routine, it will only take you a few minutes to check the latest charts to see what these indices are telling you.
This quick check is something you should do before going on to your detailed analysis of the particular currency pair you are thinking of trading.
Constructing the chart for the TIPS can a little complicated as there are only a few places on
the internet which have this chart, but you can find it here : http://www.research.stlouisfed.org Click on the Data Tools tab and from the drop down box select the 'create your own graphs' option. This will then open your FRED graph where you can create your own TIPS spread chart. To do this, enter the following ticker – DGS10 - in the Add Data Series box. This is the 10 year Treasury Constant Maturity Note.
Once done, click on the Add Data Series below to add your second instrument which in this case is – DFII10 – this is the 10 year Inflation Indexed Linked Note.
Select the same time period of 5 years or 1 year below for each instrument, and then click the redraw graph button at the bottom of the screen.
You should now have a chart with two lines one red and one blue which converge and diverge.
You now have your own TIPS spread and a personal view on inflation. Remember this is not a chart to check daily, but will help to frame some of the economic data releases, in particular when we begin to look at fundamental analysis in the next section of the book. When the Federal Reserve release their monthly statements on the economy and possible changes in interest rates in the future, this chart will help you understand why.
Your chart should now look something like the one in Fig 11.11
Fig 11.11 TIPS Courtesy of the Federal Reserve Bank of St Louis
In the previous two chapters, we looked at several of the major indices which reveal different aspects of these underlying relationships. This all helps to give us a view of the markets and, as forex traders give us a deeper insight into what is actually happening, and more importantly, what is likely to happen in the future.
This, of course, is still a relatively one dimensional view. After all an index is just an index, so in order to try to give us a more descriptive three dimensional view, we use a technique called ratio analysis.