One measure that is being used to summarize the strain in financial markets is the TED spread. This is calculated as the gap between 3-month LIBOR (an average of interest rates offered in the London interbank market for 3-month dollar-denominated loans) and the 3-month Treasury bill rate. The size of this gap presumably reflects some sort of risk or liquidity premium. I was interested to break the TED spread down into identifiable components to try to get a better understanding of what may be responsible for its recent behavior.
The TED spread over the last 5 years is plotted below; for a longer time series see Bespoke Investment Group. Historically the spread typically stayed under 50 basis points. However, it’s usually been above 100 basis points since the credit events of August 2007, and reached 300 several times during the last two weeks.
The overnight interest rate on loans between banks in the U.S. money market is the fed funds rate, whose average value is set as the primary target of U.S. monetary policy. There is also an overnight LIBOR rate, whose borrowers and lenders include some of the same banks that participate in the U.S. federal funds market, albeit a little earlier in the day. As a first step to understanding the LIBOR-TBILL spread, I was curious to look at the difference between the overnight LIBOR rate and the fed funds target. This had a rather impressive spike September 16-17.
Why would a bank want to borrow overnight dollars for 5-6% in London when it could be assured of obtaining those same funds for 2% later that day in New York? For one thing, the situation was sufficiently chaotic two weeks ago that many banks in fact were unable to borrow in New York at 2%. The effective fed funds rate (a volume-weighted average of all the known U.S. trades on a given day) was 2.64% on Sept 15 and 2.80% on Sept 17, despite the Fed’s intention to keep these numbers around 2.0. Somebody who was worried about how these days were going to unfold may have quite rationally bid quite a bit to secure the funds early. Or perhaps the U.S. banks dropped out of the London market altogether. In any case, a one- or two-day spike in this overnight rate is not that big a deal, since even a few hundred basis points (at an annual rate) is not that much money on a one-day loan. Following that impressive but brief spike, overnight LIBOR is now back to 2.31%, a modest 31 basis points over the Fed’s target.
One can break the TED spread down into separate components using the following accounting identity. Let LIBOR3 denote the 3-month LIBOR rate, LIBOR0 the overnight rate, TARGET the fed funds target, and TBILL the 3-month Treasury bill rate. The TED spread is defined as
TED = (LIBOR3 – TBILL)
which can be rewritten as
(LIBOR3 – TBILL) = (LIBOR3 – LIBOR0) + (LIBOR0 – TARGET) + (TARGET – TBILL)
As just discussed, the middle term above, LIBOR0 – TARGET, is at the time of this writing back to usual values, so the bloated value for the TED spread must be coming from a combination of the first and last terms. Indeed on Friday, the spread between the 3-month and overnight LIBOR rate stood at 145 basis points:
(LIBOR3 – LIBOR0) = 1.45
Why is the 3-month rate so much higher than the overnight rate? It certainly can’t be an expectation that the Fed’s target for the overnight fed funds rate is about to increase. If the Fed makes a move over the next 3 months (and it very well could), it would be for a decrease, not an increase, in the target. The LIBOR term spread must therefore be interpreted as some sort of a liquidity or risk premium. If I lend you funds overnight, I should have a pretty good idea of whether there’s some news coming within the next 24 hours that would prevent you from repaying. I may correctly judge that risk to be small. But over the next 3 months, who knows what might happen? If I were a risk-neutral lender, and I thought there was a 0.36% chance that a currently sound bank may go completely bankrupt over the next 90 days, I’d want a 145-basis point (annual rate) premium on the 3-month loan as compensation. If I were risk averse, I would require that 145-basis-point compensation even with a much lower probability of default.
Or, it may be that I’m afraid I myself might be exposed to some severe credit event over the next 3 months, and would be better off keeping any extra cash in Treasuries rather than lending them 3 months unsecured. I would describe this consideration as a “liquidity premium” as opposed to a “risk premium”.
If leading financial institutions are making these sorts of assessments of the probabilities of risk or liquidity needs, it bespeaks a very unsettled financial market that is apt to function poorly at channeling funds to any of the other inherently risky economic investments whose funding is vital for a functioning economy.
But this risk/liquidity premium only accounts for half of the TED spread. The remainder is due to the gap between the fed funds target (currently 2.0%) and the yield on 3-month Treasuries (now under 1%). This is the other part of the “flight to quality” just discussed. But on the other hand, the (TARGET – TBILL) gap is also a deliberate choice of policy. The Fed could simply lower its target for the fed funds rate, and chase the T-bill rate down to zero, if it wanted.
What’s the downside to that? Here’s the next shoe that could drop: the financial dislocations could lead to a perception by global investors that the U.S. is no longer a safe place to be putting their capital, which could add a currency crisis component to the present financial turmoil. Greg Mankiw notes this report:
China’s government moved to calm financial markets Thursday and denied a report that it had ordered mainland banks to curb lending to U.S. banks, a day after rumors of financial stability led to a run on a Hong Kong institution.
Calm again for the time being, I guess. But if a cut in the fed funds rate leads to rapid dollar depreciation and commodity inflation, it could be pulling the trigger on something even scarier than what we’ve seen so far.
Not an attractive set of options on the menu for the FOMC.