The TED spread: gauging confidence in financial markets

Hurricane Ike roared across the Texas coastline at 2:00 AM local time on Saturday 13 September, smashing into Galveston Island with sustained winds of 161 kilometers per hour (100 mph) that ripped roofs and walls off buildings. Houston, the United States’ fourth most populous city with a metropolitan area spread over 1,558 square kilometers (601 sq mi), suffered beneath the storm. The JP Morgan Chase Tower, at 75 stories the tallest building in the state, was severely damaged along its entire east side, with office furniture, computers, and documents spewed across the downtown area and glass shards raining from its eastern side long after the worst of the storm had passed.

Hurricane Ike is a fitting symbol of the crisis currently rocking the world’s financial system.

In March 2008, the collapse of investment bank Bear Stearns shocked financial markets throughout the world. Currently eleven smaller U.S. banks have also failed, including the infamous IndyMac, while mortgage lenders Fannie Mae and Freddie Mac were seized by the Federal government, Merrill Lynch agreed to takeover by the better-funded Bank of America, Lehman Brothers proved not so lucky and was forced to declare bankruptcy, and insurance giant AIG required massive loans to remain solvent.

The shocks were not confined to the U.S. and European banks also rocked on their moorings. A German regional bank, Sachsen Landesbank, was sold to a rival rather than allowed to collapse, and in the U.K. Northern Rock required nationalisation. Around the world, banks of all stripes and calibres began writing down massive sums while profits tumbled, and refinancing efforts included £12bn for Royal Bank of Scotland and SwFr16bn for UBS.

Investors evacuated risky propositions and made for safe havens. Global stock markets extended losses, commodities crashed, carry trades were unwound, and massive amounts of money were poured into Treasury notes, so much so that at one time the return on four-week bills dropped below zero—with willing buyers.

Meanwhile, banks remain reluctant to lend funds to each other. With financial information thin on the ground and exposure to toxic loans unknown and incalculable, it has become impossible for banks to judge the risks involved in such transactions. As a result, the amount of money (liquidity) available in financial markets is meagre and the rates charged rising, with banks being charged one amount for a three-month note and the U.S. Treasury being charged another.

This so-called TED spread is the key for forex traders to judge market stability. Readily available as a chart from Bloomberg.com (http://www.bloomberg.com/apps/quote?ticker=.TEDSP%3AIND), the TED spread normally remains around or below 100bps but rises or “widens” when investors are nervous, meaning the forex trading market will be more erratic and volatile, reflecting investors’ lack of confidence and the movement of large amounts of money from one currency to another as they seek safe harbours for their funds. During this week’s financial hurricane, the TED spread widened to 310bps and currencies fluctuated wildly, as illustrated below by the one-hour chart of USD/CAD, jittering about its 200-day moving average:

Sometimes it’s best to wait for calmer financial waters rather than buck an erratic market. While volatility is the forex trader’s friend, as waves are for the surfer, there can be too much of a good thing.