Let’s talk about the TED Spread for a moment. You don’t hear as much about this number these days as you did last fall. That should be good because the rise of the TED Spread was an indicator that we were in a financial crisis. It’s fallen by hundreds of basis points, which should be a cause for celebration. So why aren’t we celebrating?
Because the TED Spread is no longer a reliable indicator of much of anything.
The TED Spread, which is the gap between the 3-month London interbank lending rate and 3-month Treasury bill rate, was traditionally viewed as a measure of financial distress. Last fall, the TED Spread lept up to historically unprecedented numbers. Now it is back down to a still elevated level of about 100 basis points, which many believe indicates good news for the economy.
Unfortunately, the equity markets don’t seem to have come around to this point of view. Although banks are lending to each other, that’s what LIBOR measures, investors are still wary about the financial health of financial institutions. This has created something of a puzzle for market watchers who wonder if equity investors aren’t acting irrationally or somehow are simply behind the curve, failing to catch up to credit markets.
The real solution to the puzzle, however, is even grimmer. What’s happened is that government rescues broke the credit markets, making them an unreliable indicator of financial health and economic strength. By offering banks the ability to issue government guaranteed debt and promising to support banks by almost any means necessary, we may have broken the ability of the TED Spread to be a reliable indicator of anything broader in the markets. In short, the TED Spread has stopped measuring financial health; it’s simply priced off of guarantees.
Perhaps most disturbingly is that even this Guarantee Spread remains elevated. It has come down to about 100 basis points, which is still double its “ordinary level.” The TED Spread rose to that level in the summer of 2007 and has stubbornly refused to come down further, despite trillions of bailout dollars on offer from various governments.
The continued elevation of the TED Spread and the lack of equity support for the banks most likely reflects the fact that the markets have become more opaque. Stock investors can’t rely on information from the credit markets, and credit markets cannot assume the soundness of surviving financial institutions propped up by government rescues. Our rescues have been making markets murkier rather than clearer, which is a recipe for a lasting crisis.