TED Spread Update
Well, back to TED. It's time for an update. If you followed our posts in the last few months, you followed the see-saw of the TED spread moving above and below it's 50-day and 200-day moving averages. Yes, up and down, until it seemed clear that it was breaking out. Then, all of a sudden, it dropped below both averages. What was that? Apparently a head-fake, because shortly after it shot back up and we got the stock market crashing.
(Here are just few of the previous posts: HERE....HERE....and HERE...in case you missed them and are curious.)
Okay, so the TED spread did come through for us regarding the stock market. One of the things that happens when it goes up is - sometimes - the stock market falls. But that's not the main reason I follow the TED Spread. If you remember, the main reason to follow it is that it's supposed to provide some insight into credit risk in the economy. Specifically, the TED Spread reflects the credit risk of lending to commercial banks. When the spread increases - as it has been now - it's a sign that lenders believe that the risk of default on interbank loans is increasing.
The reason that matters to us is this: if banks are afraid to loan money to each other, then we're going to wind up with another credit crisis like we had in 2008. Banks stopped lending to each other and the financial system ground to a halt.
The reason the financial system ground to a halt was that the "grease" in the system is this inter-bank lending. The financial system of the world relies on the ability of banks to lend to each other - specifically to lend each other money overnight. At the end of each day, a bank has to have balanced books. But sometimes payments to and from banks don't "clear" every day exactly on time. So sometimes a bank winds up in a deficit for the day, and that's technically a default. Because the system doesn't balance perfectly every day, if Bank A has a deficit, then chances are Bank B has a surplus. So Bank B lends its surplus to Bank A overnight so Bank A won't be in technical default. Bank B earns interest on the loan. The system works when banks all trust each other - trust that their loan will be repaid in full with interest.
But under certain conditions, banks get nervous and they sometimes get to the point where they no longer trust the ability of other banks to re-pay that overnight loan. (This is a simplistic explanation, but not inaccurate.) So they won't lend overnight. And when that happens, no banks will lend, credit dries up and therefore the system doesn't work. There's no more grease (overnight lending) to keep the gears going. The gears grind to a halt.
Since the system is big and complicated, with millions of transactions taking place between banks on a daily basis, if banks don't trust each other, the world's banking system stops working.
Anyway, with the TED Spread rising now, we could be looking at a looming credit crisis. What would be the cause? Hard to say exactly. The European debt crisis certainly lies at the bottom of this, but the question is what specifically about it is heating up right now? Here's one idea I just came across: the banning of short-selling by European stock markets.
Some European countries are banning short-selling. They think it will ease the credit crunch that is being caused by the European sovereign debt crisis. So they're banning short-selling. But, as is typical of government intervention, they may be an unintended consequence that they've missed.
Banks engage in short-selling to hedge their risks of doing business with other banks. So if they can't hedge their transactions, then maybe they'll lose confidence in doing business. Maybe, without the ability to engage in short-selling, they'll cut down or even stop doing business with other banks. Maybe, for example, they'll stop lending overnight - as described above.
So maybe the TED Spread is rising right not because of the ban on short-selling.
(Here are just few of the previous posts: HERE....HERE....and HERE...in case you missed them and are curious.)
Okay, so the TED spread did come through for us regarding the stock market. One of the things that happens when it goes up is - sometimes - the stock market falls. But that's not the main reason I follow the TED Spread. If you remember, the main reason to follow it is that it's supposed to provide some insight into credit risk in the economy. Specifically, the TED Spread reflects the credit risk of lending to commercial banks. When the spread increases - as it has been now - it's a sign that lenders believe that the risk of default on interbank loans is increasing.
The reason that matters to us is this: if banks are afraid to loan money to each other, then we're going to wind up with another credit crisis like we had in 2008. Banks stopped lending to each other and the financial system ground to a halt.
The reason the financial system ground to a halt was that the "grease" in the system is this inter-bank lending. The financial system of the world relies on the ability of banks to lend to each other - specifically to lend each other money overnight. At the end of each day, a bank has to have balanced books. But sometimes payments to and from banks don't "clear" every day exactly on time. So sometimes a bank winds up in a deficit for the day, and that's technically a default. Because the system doesn't balance perfectly every day, if Bank A has a deficit, then chances are Bank B has a surplus. So Bank B lends its surplus to Bank A overnight so Bank A won't be in technical default. Bank B earns interest on the loan. The system works when banks all trust each other - trust that their loan will be repaid in full with interest.
But under certain conditions, banks get nervous and they sometimes get to the point where they no longer trust the ability of other banks to re-pay that overnight loan. (This is a simplistic explanation, but not inaccurate.) So they won't lend overnight. And when that happens, no banks will lend, credit dries up and therefore the system doesn't work. There's no more grease (overnight lending) to keep the gears going. The gears grind to a halt.
Since the system is big and complicated, with millions of transactions taking place between banks on a daily basis, if banks don't trust each other, the world's banking system stops working.
Anyway, with the TED Spread rising now, we could be looking at a looming credit crisis. What would be the cause? Hard to say exactly. The European debt crisis certainly lies at the bottom of this, but the question is what specifically about it is heating up right now? Here's one idea I just came across: the banning of short-selling by European stock markets.
Some European countries are banning short-selling. They think it will ease the credit crunch that is being caused by the European sovereign debt crisis. So they're banning short-selling. But, as is typical of government intervention, they may be an unintended consequence that they've missed.
Banks engage in short-selling to hedge their risks of doing business with other banks. So if they can't hedge their transactions, then maybe they'll lose confidence in doing business. Maybe, without the ability to engage in short-selling, they'll cut down or even stop doing business with other banks. Maybe, for example, they'll stop lending overnight - as described above.
So maybe the TED Spread is rising right not because of the ban on short-selling.
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