A Rick Santelli View...

The TED Spread, albeit still historically high, came down from the highs last week. I would be hard-pressed to call it a ‘rally’, but at least more faith is being shown that the government is doing the right thing.

What is the TED Spread? The TED Spread is defined as the yield difference between the [risk-free rate] United States three month Treasury Bill and the three month London Interbank Offered Rate (LIBOR).

What does it mean? The TED spread is a way of taking the pulse of global credit risk. The three month T-Bill is considered ‘risk-free’ because of the full faith and credit backing of the US Government (i.e. no default risk). To compare that to the LIBOR reflects the credit risk of unsecured lending between banks in the London interbank market. In a nutshell, a rising TED spread indicates what we have now- fear of the default risk. Low spreads indicate more of an appetite/tolerance for risk in a ‘safe’ economy.

What other data supports the TED Spread? Many economists argue that the LIBOR-OIS spread is the complement to the TED spread. The LIBOR-OIS spread measures the difference between LIBOR and the overnight index swap rate. The rate has been viewed as confirming the credit risk by “measuring the availability of funds in the market” ( Bloomberg ).

Bullbeartrader.com put out this paragraph that perfectly summarizes the spreads: “As discussed in a recent Bloomberg article, the spread between the 3-month Libor and the overnight index swap (OIS) rate, traded forward 3 months, is greater than similar expiring spreads. This recent movement in the spread is signaling that traders are concerned that banks will have difficulties obtaining cash to fund existing assets, as well as putting into question their ability to shore-up their balance sheets. In general, an increasing spread signals that funds are becoming less available. The recent activity appears to be driven more by traders leaving the short-term, closer to expire positions early over worries about Libor and its reliability” (BullBearTrader).

Back in May, MarketBeat’s David Gaffen also pointed out that the TED spread improved (fell) because of the T-Bill rates rising, not LIBOR rates decreasing. Now, we are seeing the complete opposite (TED rising). Investors are now flooding into T-Bills and thus sending prices higher and yields lower. To think - investors at one point in time were willing to put their money in 0% yield instruments.

Conclusion:
The scary part is that the U.S. three month T-Bill traded at either zero or even negative late last week. While it has recovered, the TED spread is still too high and I am sure the Federal Reserve is paying close attention to it, among other factors. After holding rates steady, the Fed will surely have the finger on the ‘ease-rate button’ should emergency intervention be needed pending Congress’ vote on the Paulson bailout plan.

Below:
The first chart shows the dramatic volatility in the TED itself. It has historically charted between only a few basis points, but the recent events in the U.S. have created a spike that finally broke out.

The second chart gives a closer view of what has been going on the past year. We finally got the biggest spike in the TED after a week that changed Wall Street forever. Although it has subsided from its highs, the TED is worth watching as a future indicator, pending the government's solution.

Charts are (c) of http://www.bloomberg.com