Watching the spreads

In a credit crunch, it's not the daily stock market oscillations that tell the story of progress or decline.

By Tim Duy

One of the most important lessons I teach my students is that if you insist on trying to monitor the daily movements of the stock markets to track the direction of the economy, you will always be overtaken by events. In fact, it's best to ignore the daily fluctuations of the stock market entirely. Focus instead on credit-market indicators: LIBOR and its cousin, the TED spread.

LIBOR, the London Interbank Offered Rate, is the rate that banks charge for interbank loans of sizeable quantities. When experts say that credit is "freezing up," chances are LIBOR is soaring relative to risk-free assets as the willingness to lend falls just as the demand for funds rises.

In recent days, LIBOR has edged back upwards even as stock markets rose, drawing interest from financial analysts and the media alike. Should we be worried? Does LIBOR's rise suggest a setback for efforts to stabilize the international financial system? Or is it simply a bump on the road to recovery?

In short, LIBOR's recent rise is relatively small and may be attributable to cyclical factors that will likely soon fade -- not yet a cause for concern. But there are good reasons to watch the indicator in coming months as the credit markets recover and wean themselves from massive government injections.

Periods of heightened risk aversion often signal problems in financial markets that inhibit the free flow of capital -- what is commonly known as a "credit crunch." The impact of a credit crunch can be devastating, as the rapid contraction in demand that typically follows can send an economy into virtual free fall. The world saw a perfect example of this in the global economy's rapid deceleration during the final months of 2008.

Of course, one can't look at LIBOR in a vacuum. If the Fed raises interest rates 100bp because the economy is improving, then LIBOR should rise as well. Consequently, economists and policymakers watch the spread between rates of return on fixed income assets with similar maturities as an indication of risk aversion in credit markets. One such measure of credit market stress is the TED spread (from Treasury and Eurodollars). This index compares U.S. Treasury rates -- considered to be "risk free" -- and LIBOR interbank lending rates. The result measures the perceived riskiness of interbank lending relative to riskless U.S. Treasuries. The TED spread usually fluctuates between 10 and 50 basis points (bp), where one basis point is equal to .01 percent. During periods of financial stress, however, banks hoard their excess cash to cover their own needs or because they believe their counterparties -- other banks -- might default on their loans. Hoarding leaves less cash available for lending, and firms and consumers suddenly face higher costs of borrowing. Worse, they can be cut out of credit markets altogether.

In this financial crisis, the TED and LIBOR have said it all -- far more telling than the daily oscillations of the stock exchange. A rising TED spread heralded the beginning of the financial crisis a year and a half ago, breaking 100bp on Aug. 10, 2007. At the height of trouble 14 months later on Oct. 10, 2008, the spread hit 463bp as the cost of borrowing on the London interbank market rose sharply. Aggressive and unprecedented liquidity actions on the part of global central banks, intended to flood financial markets with the dollars that banks were hoarding, combined with capital injections by U.S. and UK governments, helped ease the crisis. The TED spread hit a recent low of 93bp on Feb. 11, though it rose again to 113bp on March 12, reminding us that the financial markets remain fragile. While still high relative to historical norms, and thus indicating a heightened level of perceived risk, the retreat in interbank lending rates from their highs is a welcome sign of progress in efforts to resolve the financial crisis. Optimally, we would like to see the TED spread retreat to its normal range, below 50bp.

So far, the TED spread is not signaling new danger; in contrast to steep rises last fall, the recent changes are relatively minor. (Timing also has much to do with the gains since banks are holding extra cash as they prepare for the end of the quarter.) But the recent fluctuation is a reminder that we need to maintain progress on easing financial strains. A sharp rise would signal a fresh financial storm was brewing.

More progress needs to be made (including ultimately the withdrawal of extraordinary measures on the part of the Federal Reserve such as TARP and its siblings) before we can declare financial markets healthy. The recent uptick in LIBOR is a testament to that fragility. Under normal circumstances, a healthy financial system should rely on its internal lending systems to provide the support the Fed is now offering. Ideally, the Fed's intervention will gradually lessen as the financial sector heals; premature withdrawal would trigger a fresh chapter in the crisis as firms scrambled for cash. If the healing process stalls, the Fed may be stuck in the uncomfortable position of providing financing to the economy for a long time, accepting the risk that such involvement would distort capital allocation decisions and leave the economy on a lower long-run growth path. If that happens, we'll have plenty of other indicators to worry about.

Tim Duy is adjunct assistant professor of economics at the University of Oregon.

KAZUHIRO NOGI/AFP/Getty Images