TED Spread Widening: Still the Canary in a Coal Mine?

August 11, 2016

TED Spread Widening: Still the Canary in a Coal Mine? Photo

The TED spread represents the difference between short-term Government interest rates (3-month T-Bills) and interbank lending rates (3-month LIBOR). TED is an acronym derived from T-Bill and ED, the ticker for Eurodollar futures contracts. Historically, a widening of the TED spread has provided an early warning indicator for periods of stress in the financial system and weak equity market performance. This week’s chart identifies four such periods when a widening TED spread preceded significant “risk off” environments.

The TED spread recently reached 55 basis points, the widest level in five years and double the level from just six months ago. The recent pressure is more likely driven by new money market reforms issued by the U.S. Securities and Exchange Commission (SEC) as opposed to increasing anxiety among investors. These reforms include new rules for prime money market funds (which assume corporate credit risk), requiring a floating net asset value (NAV), liquidity fees and redemption gates. BMO Capital estimates more than $1 trillion will transition from prime money funds to government money funds before October of this year, when the changes take effect.

Key Takeaway:

Investors clamoring for the Federal Reserve to tighten monetary policy may take some solace in tighter credit conditions resulting from SEC money market reforms. Even though the consensus view is downplaying the significance of recent widening in the TED spread, investors should keep a close eye on the spread for the remainder of this year. In a world where asset values have been supported by unprecedented monetary stimulus, financial markets appear vulnerable to even minimal disruptions. In particular, European and Japanese banks (already struggling with negative interest rates) will need to find new sources of dollar funding after relying heavily on U.S. money market funds for short-term borrowing.

Tags: Chart of the Week | Monetary policy | Leading indicators | TED Spread | LIBOR | Securities and Exchange Commission (SEC)

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