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August 7, 2016 | TED Spread Widening – Significant or Not? LIBOR Scandal Revisited

Mike 'Mish' Shedlock

Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

 

The TED Spread is the difference between the interest rates on interbank loans and on short-term U.S. government debt.

The “T” stands for treasuries, and “ED” is the futures symbol for the Eurodollars contract (a measure of expected interest rates in US dollars, not at all related to euros).

Investopedia defines TED Spread as The price difference between three-month futures contracts for U.S. Treasuries and three-month contracts for Eurodollars having identical expiration months.

The TED Spread is rising. So what does that mean? How does it tie into the LIBOR scandal?

For discussion, let’s take a look at the Variant Perception article More TED Spread Widening on the Way.

One of the early warning signs of the 2008 crisis was the widening in credit spreads such as the Ted spread and the Libor-OIS spread. There was a run on the shadow banking system as the credit-worthiness of many financial institutions came under suspicion in the wake of the housing crisis. Banks’ traditional forms of short-term funding such as certificates of deposit (CD) and commercial paper (CP) dried up. As a result Libor, which is supposed to reflect bank funding costs, began to rise inexorably.

TED 1

Today, we are seeing some widening in the Ted spread (red line, chart below) – but for what should be predictable reasons. More onerous regulations, which are due to come into effect on October 14th, are leading to less demand for so-called prime money market funds. Given that they invest about 60% of their assets in CD and CP, this is causing bank funding costs to rise, and so Libor has been rising. The Libor-OIS spread has been widening (black line, chart below), which is reflective of tougher bank funding, but does not necessarily imply a bank-funding crisis is on the cards as this new regulation has been known about for some time. However, should Libor-OIS not stabilize then this would indicate a potential bigger problem. The Ted spread should also widen more over the next few months as money moves from prime funds to government funds, which implies higher Libor and lower UST bill yields.

TED 2

LIBOR Discussion

That’s likely still not clear. Moreover there are new terms to explain for many. Stay with us for a bit, and for an interesting flashback at the LIBOR rigging scandal.

LIBOR is the “London Interbank Offer Rate”, the interest rate at which banks are willing to lend US dollars to each other, overnight. It is a stated rate, not necessarily reflective of any real transactions.

During the crisis, it was rigged. The New York Times article Tracking the Libor Scandal details the scandal.

Barclays, UBS, Royal Bank of Scotland, ICAP, Rabobank all pleaded guilty or paid fines. In December of 2013, in one fell swoop, Citigroup, JPMorgan Chase, Deutsche Bank, Royal Bank of Scotland and Société Générale were all found guilty of manipulation. In 2104, RP Martin, Lloyds, and four other banks were implicated.

LIBOR Scandal

In a set of rare convictions of anything that happened during the great financial crisis, a former Citigroup and a UBS trader were convicted in 2015.

Select Quotes From NY Times

  1. Barclays trader to an official: “We know that we’re not posting, um, an honest” rate.
  2. Bank of England official in an email: “They will obviously have to remove the references to us and Fed”
  3. Barclays email: Traders seeking favorable rates received a welcome reception from bank employees who set the benchmark. “Always happy to help,” one employee said in an e-mail.
  4. UBS: “I need you to keep it as low as possible,” one UBS trader said to an employee at another brokerage firm in 2008, according to the complaint. The trader promised to pay “whatever you want. I’m a man of my word.”
  5. ICAP: One trader resorted to begging, invoking a plea of “pretty please.” Another trader, after pressuring a colleague to submit a certain rate, offered a reward of sorts: “I would come over there and make love to you.”
  6. Rabobank: When one trader requested a specific rate and then expressed concern that the submitter might encounter resistance, the submitter replied: “Don’t worry mate — there’s bigger crooks in the market than us guys!”
  7. Deutsche Bank: “I’m begging u, don’t forget me,” one Deutsche Bank trader wrote in an online chat to an employee at a rival bank, seeking to influence rates. “Pleassssssssssssssseeeeeeeeee … I’m on my knees …”

Pay particular attention to point number 2. The Fed and Bank of England were involved in the scandal and/or coverup of the scandal.

Who was convicted? Two lowly traders.

LIBOR-OIS Spread Discussion

OIS stands for Overnight Index Swap Rate. For an explanation please consider Understanding Overnight Index Swaps.

Imagine Institution #1 has a $10 million loan that it is paying interest on, and the interest is calculated based on the overnight rate. Institution #2, on the other hand, has a $10 million loan that it is paying interest on, but the interest on this loan is based on a fixed, short-term rate of 2 percent. As it turns out, Institution #1 would much rather be paying a fixed interest rate on its loan, and Institution #2 would much rather be paying a variable interest rate—based on the overnight rate—on its loan, but neither institution wants to go out and get a new loan and they can’t renegotiate the terms of their current loans. In this case, these two institutions could create an overnight index swap (OIS) with each other.

The overnight rate in constantly changing, and you will pay a different interest rate at 6:00 am than you will pay at 11:00 am.

To resolve this issue, an overnight index swap rate is calculated each day. This rate is based on the average interest rate institutions with loans based on the overnight rate have paid for that day.

The overnight index swap (OIS) market is quite large, and the movements in this market can provide a lot of information for economists and analysts who are trying to understand what is happening in the global financial markets. One of the key pieces of information analysts watch is the interest rate the institutions who have loans with variable interest rates are paying.

Crisis Rates

Crisis Rates

The above from The Derivatives Discounting Dilemma by John Hull.

Rise in the TED Spread

With those historical tidbits out of the way, let’s return to the initial discussion of rising TED spreads. The following chart from Macro Trends provides a much better time line for discussion.

Ted Spread 2016-08-06

The direction is problematic, but are the volatility and magnitude of sufficient size to indicate real problems?

I don’t know. But it does merit watching. And central banks are likely watching very closely. They do not want a repeat of the crisis or even of the taper tantrum that occurred when the Fed first hinted rate hikes may be on the way and they would taper asset purchases.

Then again, volatility suppression mechanisms work, until they finally explode. There may be no warning next time.

Mike “Mish” Shedlock

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August 7th, 2016

Posted In: Mish Talk

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