Many indicators provide clues to the future performance of one or more capital market asset classes. Unfortunately, none is perfect, otherwise 2008 might not have become so ugly.
There are two useful indicators that bond investors would do well to heed: the London Interbank Offered Rate (LIBOR) and the TED spread (a contraction of Treasury bill and eurodollar; its futures rate was the second component of the TED spread until the LIBOR replaced it).
LIBOR is the average interest rate at which commercial banks lend money to one another. It is the primary benchmark for worldwide short-term interest rates. LIBOR – calculated for 10 currencies and 15 borrowing periods, ranging from overnight to one year – is published daily. Many financial institutions, mortgage lenders and credit card agencies set their rates relative to it.
Following a recent scandal in which Barclays Bank and other member banks colluded to falsify the LIBOR rate, the British Bankers’ Association is scheduled to transfer oversight of LIBOR to UK regulators.
The TED spread is the difference between the three-month LIBOR and the three-month U.S. Treasury bill rate (the interest rate at which the U.S. government borrows money for three months). It reflects the additional premium that a lender requires in order to accept the risk that the bank that receives the loan might default, compared to lending the same amount to the U.S. government instead. In effect, it’s a measure of the premium required for commercial lending over what is considered a risk-free investment. As such, it’s a good overall indicator of perceived economic credit risk. The higher the number, the riskier interbank lending is considered to be and, consequently, the less liquidity will be available in the bond markets.
As of the date of this writing, the three-month LIBOR is 0.31 percent and the three-month U.S. Treasury bill rate is 0.10 percent, making the TED spread 0.21 percent. That’s below the historical average of 0.30 percent, implying that there are currently no major perceived risks to the worldwide credit markets.
However, Oct. 10, 2008, the U.S. Treasury rate dropped to 0.25 percent and the LIBOR rose to 4.90 percent, driving the TED spread to a whopping 4.65 percent. That signaled the beginning of the credit crisis from which the worldwide economy is still recovering. And if you think that was bad, in 1980, the TED spread climbed to 4.78 percent. This was during a time when the U.S. Prime Rate hit 20 percent and inflation raged.
It would be helpful if these indicators gave us some advance warning of a severe credit crunch, but unfortunately they generally don’t peak until after the crisis has occurred and the investment markets have already adjusted (usually severely downward). Nonetheless, they provide a concurrent indication of credit activity and are worth following.
The current three-month LIBOR rate is available online at www.bankrate.com/rates/interest-rates/libor.aspx.
The TED spread is more difficult to locate but is easily calculated using LIBOR and U.S. Treasury rates. Crystal Bull, a website that provides access to multiple market and economic indicators, currently provides a useful interactive chart at no cost. To view the graphs, visit www.crystalbull.com/stock-market-timing/TED-Spread-chart.
Los Altos resident Artie Green is a Certified Financial Planner with Cognizant Wealth Advisors. For more information, call 209-4062.