Ted spread: Meaning, Criticisms & Real-World Uses

What Is Ted Spread?

The Ted spread is a financial indicator that measures the difference between the interest rate on interbank loans and the interest rate on short-term U.S. government debt. It belongs to the broader category of Financial Indicators and is specifically a type of credit spread. The "TED" acronym derives from "T-bill" (Treasury bill) and "ED" (the ticker symbol for Eurodollar futures contracts)²⁶. This spread is crucial because it provides a snapshot of the perceived credit risk in the banking system and the overall liquidity risk in financial markets²⁵. A widening Ted spread suggests increased concern about banks' ability to lend to one another, implying a higher credit risk among financial institutions.

History and Origin

The Ted spread gained prominence as a key barometer of financial health, particularly during periods of market stress. Historically, the Ted spread was initially calculated using the difference between the interest rates on three-month U.S. Treasury futures and three-month Eurodollar futures. However, after the Chicago Mercantile Exchange (CME) discontinued T-bill futures following the 1987 stock market crash, the calculation evolved to use the three-month London Interbank Offered Rate (LIBOR) directly against the three-month Treasury bills (T-bills) interest rate.

The spread became a widely watched indicator, especially during the 2008 financial crisis, when it dramatically widened, signaling severe distress in the banking sector²⁴. For instance, the Ted spread, which typically hovered between 10 and 50 basis points, surged to over 300 basis points in September 2008 and reached a high of 457 basis points in October 2008 following the collapse of Lehman Brothers²³. This historical behavior cemented its role as a quick reference for assessing market sentiment and the perception of economic health. The Federal Reserve Bank of San Francisco noted that the Ted spread's wide fluctuations reflected substantial anxiety about credit risk during this period.²²

Key Takeaways

The Ted spread is the difference between the 3-month LIBOR and the 3-month U.S. Treasury bill yield.
It serves as a widely recognized indicator of perceived credit risk and liquidity in the financial system.
A widening Ted spread indicates increasing concerns about the health of banks and a tightening of interbank lending.
Historically, significant spikes in the Ted spread have coincided with major financial crises and economic downturns.
While useful, the Ted spread has limitations, particularly with the discontinuation of LIBOR.

Formula and Calculation

The Ted spread is calculated by subtracting the interest rate of a three-month U.S. Treasury bill from the three-month London Interbank Offered Rate (LIBOR). Both rates are typically denominated in U.S. dollars. The result is usually expressed in basis points (bps), where 100 basis points equal 1%²¹.

The formula is:

\text{Ted Spread} = \text{3-month LIBOR rate} - \text{3-month Treasury bill rate}

Where:

3-month LIBOR rate: The average interest rate at which major global banks lending to one another in the London interbank market for a three-month period. It represented the cost of unsecured interbank lending. The Financial Conduct Authority (FCA) confirmed the cessation of all LIBOR settings by end-September 2024.²⁰,¹⁹,¹⁸
3-month Treasury bill rate: The yield on short-term U.S. government debt with a three-month maturity.,¹⁷ T-bills are considered virtually default risk-free due to the backing of the U.S. government.¹⁶

Interpreting the Ted Spread

Interpreting the Ted spread hinges on understanding what each component represents. The LIBOR component reflects the cost of borrowing for banks, encompassing the credit risk associated with lending to commercial institutions. The Treasury bill component, conversely, represents a near risk-free rate, as U.S. government debt carries minimal perceived default risk.

A low or narrowing Ted spread typically signifies that banks are confident in each other's creditworthiness and that liquidity is ample in the money markets. Historically, a Ted spread between 10 and 50 basis points was considered normal.

Conversely, a widening Ted spread indicates that banks are demanding a higher premium to lend to each other than the U.S. government. This suggests increased concerns about counterparty risk, a tightening of credit conditions, and a potential reduction in short-term debt availability for financial institutions¹⁵. Such conditions can signal financial market stress or an impending financial crisis.

Hypothetical Example

Suppose on a given day, the 3-month LIBOR is quoted at 1.85%, and the yield on the 3-month U.S. Treasury bill is 0.45%.

To calculate the Ted spread:

\text{Ted Spread} = 1.85\% - 0.45\% = 1.40\%

Expressed in basis points, this would be 140 bps.

In this scenario, a Ted spread of 140 basis points would be considered significantly elevated compared to historical norms (e.g., 10-50 bps)¹⁴. This elevated spread would indicate heightened concern among banks regarding the creditworthiness of their peers and the overall availability of funds in the interbank lending market. It suggests that banks perceive a greater risk when lending to other banks than when investing in virtually risk-free U.S. government securities.

Practical Applications

The Ted spread has historically been a critical tool for financial professionals and policymakers for several practical applications:

Market Stress Indicator: The most prominent application of the Ted spread is its use as a leading indicator of market volatility and financial system stress. A sharp increase signals a flight to safety, where investors move out of riskier assets into highly liquid, safe government bonds, simultaneously reflecting banks' reluctance to lend to each other¹³. For example, during the 2008 financial crisis, Reuters reported that the Ted spread signaled deep distress in the market.¹²
Economic Forecasting: While not a perfect predictor, a widening Ted spread has often preceded economic downturns. This is because tightening credit conditions can hinder business activity and investment, leading to broader economic contraction¹¹.
Risk Management: Banks and financial institutions monitor the Ted spread to gauge systemic risk. A rising spread might prompt them to tighten their own lending standards or increase their capital reserves to mitigate potential counterparty risk.
Investment Decisions: Investors may use the Ted spread as part of their analysis for allocating capital. A widening spread could signal caution and a shift towards more conservative investments, while a narrowing spread might indicate improving conditions and a willingness to take on more risk in assets like commercial paper.

Limitations and Criticisms

While historically a valuable indicator, the Ted spread has faced limitations and criticisms, particularly with the global transition away from LIBOR.

Reliance on LIBOR: The primary criticism stems from its dependence on LIBOR, which was phased out due to concerns about its manipulation and the dwindling number of underlying transactions it reflected¹⁰. The Financial Conduct Authority (FCA) has overseen the cessation of LIBOR, making the original Ted spread calculation method obsolete for new contracts⁸, ⁹. While synthetic LIBOR settings were temporarily published, their representativeness for gauging market health decreased.⁷,⁶
Simplicity: The Ted spread is a relatively simple measure. It doesn't capture the full complexity of financial market conditions or the nuances of various funding markets. Other, more sophisticated indicators of systemic risk are employed by central banks to provide a broader assessment of financial stability.
Lagging or Coincident Indicator: In some instances, the Ted spread may react to events rather than predict them with a significant lead time. For example, its sharpest spikes often occurred during a crisis rather than far in advance.
Influenced by Non-Risk Factors: Factors unrelated to perceived credit risk, such as regulatory changes, could influence LIBOR and, by extension, the Ted spread. For instance, certain regulatory requirements for money market funds in 2016 caused an elevation in LIBOR rates, impacting the Ted spread even without a corresponding increase in systemic credit risk.

As financial markets evolve, new spreads, such as those involving the Secured Overnight Financing Rate (SOFR), are emerging as alternatives to track credit and liquidity conditions.

Ted Spread vs. LIBOR-OIS Spread

Both the Ted spread and the LIBOR-OIS spread are credit spreads that have historically provided insights into financial market health, but they differ in their components and the specific aspects of risk they aim to capture.

The Ted spread measures the difference between the 3-month LIBOR and the 3-month Treasury bill yield. Its core purpose is to gauge the perceived credit risk in the banking sector relative to a virtually risk-free government borrowing rate. A widening Ted spread suggests heightened concerns about banks' creditworthiness and a tightening of conditions in the broader commercial paper and interbank lending markets.

The LIBOR-OIS spread, on the other hand, is the difference between LIBOR and the Overnight Index Swap (OIS) rate for a given tenor⁵. An OIS rate is tied to an overnight benchmark rate, such as the federal funds rate in the U.S., which carries very little credit risk. Therefore, the LIBOR-OIS spread specifically highlights the credit component within the interbank lending market itself, isolating the premium banks demand for lending unsecured funds to each other over a risk-free (or near risk-free) overnight rate⁴.

While both spreads serve as indicators of financial stability, the Ted spread compares bank funding costs to government debt, reflecting broader market anxiety. The LIBOR-OIS spread, conversely, focuses more acutely on the perceived creditworthiness within the interbank market itself, reflecting banks' willingness to lend to each other without collateral. The discontinuation of LIBOR means both original spreads are no longer actively calculated, leading to the development of new benchmarks for tracking similar market dynamics.

FAQs

What does a high Ted spread indicate?
A high or widening Ted spread indicates increasing concern among lenders about the creditworthiness of banks and a general tightening of credit conditions. It suggests that banks perceive a higher risk when lending to other banks than when investing in low-risk government securities, potentially signaling a lack of market liquidity or a broader financial strain.

Is the Ted spread still used today?
The traditional Ted spread, which relied on LIBOR, is no longer actively calculated as LIBOR has been phased out³. However, the concept of comparing bank funding costs to risk-free government rates remains relevant, and similar spreads using new reference rates (e.g., SOFR-based rates) are now monitored to assess credit risk and market conditions.

How does the Ted spread relate to a financial crisis?
The Ted spread has historically spiked dramatically during periods of financial crisis. For example, during the 2008 financial crisis, the Ted spread surged to unprecedented levels, reflecting extreme fear and a severe contraction in interbank lending as banks became highly distrustful of each other's ability to repay loans². Its rapid widening often signals a breakdown in confidence within the financial system.

What is a normal range for the Ted spread?
Historically, the Ted spread typically fluctuated within a range of 10 to 50 basis points (0.1% to 0.5%) during periods of relative market stability¹. Readings significantly above this range would historically indicate heightened financial stress.