The Problem With the TED Spread

Felix points out a potential issue with relying on the TED spread as measure of financial system distress:

...so long as banks can borrow from the central bank overnight, the TED spread is largely unrelated to their real-world cost of capital. Which doesn't make me an optimist, by any means. But I do think that the TED spread can remain elevated for some time without the world coming to an end.

Another problem with the TED spread, which is the difference in the rates on 3-month Libor and 3-month Treasury bills, is that during times of distress, demand for Treasuries rise, pushing down the yield and opening up the TED spread. The reason this is a problem is that the universe of Treasury investors and interbank entities is not one and the same.

So to get a cleaner sense of inter-bank distress, economists have been tracking Overnight Index Swap rates. Here's a nice explanation why, from State Street's Dan Peirce:

An overnight indexed swap exchanges a fixed level of interest, the OIS rate, for the amount earned by fed funds over the term of the swap. The counterparties to such a swap bear minimal credit risk, as they simply make payment based on the difference between a fixed rate and a stream of variable rates. With a conventional Libor loan, by contrast, the lender bears the credit risk of the borrower for the entire principal plus the Libor interest.

As commenter dWj mentions in Felix's comments, the spread then between 3-month OIS rates and Treasury bill rates can be a measure of the presence of a safehaven bid:

Treas.Libor.gif

And here is a plot of the OIS rate and the target for the federal funds rate:

Movements in the OIS rate have tended to anticipate Fed interest rate changes. Since the latest episode of the credit crunch with Lehman's failure and the money market shut-down two weeks ago, the OIS rate has deviated southward from the rate target suggesting -- like other interest rate futures -- that despite a bailout, the Fed will cut soon.

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