Two Useful Indicators of Bond Market Liquidity

Two Useful Indicators of Bond Market Liquidity

There are many indicators that provide clues as to the future performance of one or more capital market asset classes.  Unfortunately none are perfect, otherwise 2008 might not have turned out so ugly.  Today I’d like to explain two useful indicators that bond investors would do well to heed: LIBOR and the TED spread.

LIBOR, or the London Interbank Offered Rate, is the average interest rate at which commercial banks lend money to each other.  It is the primary benchmark for worldwide short term interest rates.  LIBOR rates are calculated for ten currencies and 15 borrowing periods ranging from overnight to one year and are published daily.  Many financial institutions, mortgage lenders and credit card agencies set their own rates relative to it.  Due to a recent scandal in which Barclays Bank and other member banks were discovered to have colluded to falsify the LIBOR rate, the British Bankers’ Association will be transferring oversight of LIBOR to UK regulators.

The TED spread is the difference between the 3-month LIBOR and the 3-month U.S. Treasury bill rate (the interest rate at which the U.S. government borrows money for 3 months).  It reflects the additional premium that a lender requires in order to accept the risk that the bank to which it loans the money might default on the loan, as compared to lending the same money to the US 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 more risky inter-bank lending is considered to be, and consequently the less liquidity there will be available in the bond markets.  (Note that “TED” is a contraction of Treasury bill and EuroDollar, whose futures rate was the original second component of the TED spread before being replaced by the LIBOR).

As of the date of this writing, the 3-month LIBOR is 0.31% and the 3-month U.S. Treasury bill rate is 0.10%, making the TED spread 0.21%.  That’s below the historical average of 0.30%, implying that there are currently no major perceived risks to the worldwide credit markets.  However, on October 10, 2008, the U.S. treasury rate dropped to 0.25% and the LIBOR rose to 4.90%, driving the TED spread to a whopping 4.65%!  That signaled the beginning of the credit crisis from which the worldwide economy is still recovering today.  And if you think that was bad, in 1980 the TED spread climbed to 4.78%.  This was during a time when the U.S. Prime Rate hit 20% and inflation raged.

It would be nice 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 adjusted (usually severely downwards).  Nonetheless they do provide a concurrent indication of credit activity, and are worth following.

You can find the current 3-month LIBOR rate online at http://www.bankrate.com/rates/interest-rates/libor.aspx.  The TED spread is harder to find (although you can easily calculate it from LIBOR and U.S. Treasury rates).   Crystal Bull, a site providing access to multiple market and economic indicators, currently provides a nice interactive chart at no cost.  You can find it at http://www.crystalbull.com/stock-market-timing/TED-Spread-chart/.

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