The TED Spread

The TED spread is the difference between the yield on the 3-month U.S. Treasury bill (a safe, 3-month loan to the U.S. government) and the yield on the 3-month LIBOR (a riskier loan to a bank in the London wholesale money market.) It's an important indicator of how much trust exists between large, international banks, which also makes it a good gauge of how freely capital is flowing through the international banking system.

In general, when the TED spread is high, banks are worried that short-term loans made to other banks won't get repaid. When the TED spread is low, banks are confident that short-term loans made to other banks will be paid back.

It's important for consumers and businesses looking for loans to pay attention to the TED spread, because when the flow of capital between banks is stifled, banks in turn not only cut back on the number of loans they make, their loan products also become more expensive.

So, let say you are the owner of a large American bank that has a presence in most of the major industrialized nations of the world, including London, England. You are sitting on a pile of cash and you are interested in making some profit with that cash via a short-term loan. Specifically, you want to make a loan with a term of 3 months. You have options:

You could lend the money to the U.S. government and make a small profit. However, the benefit of lending to the federal government is that the loan would be extremely safe. In other words, the odds that the U.S. government would default on that three-month loan are extremely small. After all, the federal government has the ability and the authority to simply print more U.S. dollars if it needs to. So it's a trade off: the risk is small, but so is the profit. To make a 3-month loan to the U.S. government, you would invest in a 3-month Treasury bill.

Alternatively, you could make a 3-month loan to another bank in the London wholesale money market. The loan would be riskier than investing in a U.S. Treasury security, as a commercial or retail bank does not have the ability to print U.S. dollars. Moreover, the 3-month loan you plan to make would not be secured by any collateral. So, again, it's a tradeoff: making a short-term loan in the London wholesale money market is riskier than buying a U.S. Treasury security, but your profit would be larger. To get an idea of how much profit you could make on a 3-month, unsecured loan in the London money market, you would simply check out the yield on the 3-month London Interbank Offered Rate (LIBOR).



So, let's say the yield on a 3-month Treasury is 0.20%, and the 3-month LIBOR yield is 0.90%. The TED spread is the difference between the two, or 0.70 percentage point (which is the same as 70 basis points.) A TED spread below 50 basis points is a good indication that the global banking system is healthy. Above 50 basis points suggests that banks aren't making short-term loans to each other with confidence.

What Drives the TED Spread Higher?

A lower yield on the 3-month Treasury bill, or a higher yield on the 3-month LIBOR rate, or both.

Increased demand will cause the yield on U.S. Treasuries to decline as institutional and individual investors across the globe move money from riskier investments like stocks and corporate bonds to the safety of U.S. government debt.

The yield on the 3-month LIBOR will move higher when banks that participate in the London wholesale money market think that other banks may have problems paying back their short-term loans. The greater the perceived risk, the higher the rate.