TED spread has been moving higher

Reaction to Europe showing up in key measure of risk

Yesterday, I took a look at the 3-month LIBOR rate and discussed how the recent increased has been tied to tension in the credit markets flowing from southern Europe.

Today, I want to take some time and discuss another gauge that measures risk in the credit markets – the TED spread.  The TED spread looks at the difference between the 3-month LIBOR and the 3-month U.S. T-bill.

The 3-month T-bill is considered a risk-free rate of return because the investment is short-term and is backed by the full faith and credit of the U.S. government.

When credit markets are functioning normally, we are likely to see a very narrow spread because there is very little risk for banks to park excess reserves in either a T-bill or lend it to another bank for 90 days.

Think back to the 1990s or the mid part of the last decade. Lending funds short term to a large U.S. or European bank is an easy way to earn a little extra cash over a T-bill with a virtual guarantee of the return of principal. But in theory, it’s not quite risk free; hence, the slightly higher interest rate.

TED spread

But the sovereign debt crisis in Europe has caused an increases in skittishness among banks, who fear that a default by Greece could quickly lead to write downs at major European banks and possibly threaten the solvency of some institutions.

Therefore, funds available among banks has fallen, leading to a rise in the 3-month LIBOR rate.

Thus far, the increase in the TED spread is a reflection of what is happening in Europe, and the modest impact on credit markets is not enough to harm economic activity, in my view.

And the rise pales in comparison to what happen in the wake of the Lehman crisis, when an already elevated level between 85-100 soared to over 460, indicating credit markets were nearly frozen and the financial system was near the breaking point.

America holds very little paper from Greece, but Spain, which has been in the spotlight lately, owes U.S. institutions almost $200 billion, according to the New York Times, highlighting how interconnected countries around the world are.

The TED spread did fall slightly today, but the key measure of risk is worth watching, as it provides a good reading or temperature of  the financial markets.