TED Spread 101
The Hedge of All Hedges by Franklin Sanders
Would you be interested in a one-of-a-kind investment play that:
*Offered the premium global risk indicator, bar none?
*Works equally well hedging deflation or inflation?
*Hedges global political, financial, or currency crisis, bank failure, brokerage system bankruptcies or stock market meltdowns?
*Stands right now at a 30-year low and hasn't yet discounted major changes around the world?
*Offers the very earliest warning against panics of every kind?
*Has a practical downside risk of $750, based on past market movements, and potential upside gains of as high as $13,750?
Profiting from the Flight to Quality
Nothing spooks as quickly as money. When the first whiff of panic hits the air, money runs for cover, fleeing from illiquid, low quality instruments to liquid, high quality. The flight to quality always stems from some collapse of confidence, whether in a currency, banking or financial system, or in a future threatened by war and terrorism.
Throughout history, gold has benefited this flight to quality more than any other investment, because gold represents both quality and ultimate liquidity. Gold is the only financial asset that is not simultaneously someone else's liability.
In the last 20 years, however, paper investments and derivatives of every kind have multiplied and flourished like kudzu under the Georgia sun. Among all this profusion, the TED Spread has emerged as the prime global risk indicator and the world's anxiety index.
The TED Spread doesn't replace gold or silver hedges because it belongs to an asset class wholly distinct from them. However, it covers so many bases that every investor can benefit from holding TED Spreads to complement, but not to replace, precious metals in a crisis hedge portfolio.
What Is It?
Simply the yield difference ("spread") between 90 day U.S. Treasury bills, and 90 day Eurodollar certificates of deposit.
What is the TED Spread? Simply the yield difference ("spread") between 90 day U.S. Treasury bills, and 90 day Eurodollar certificates of deposit. Since nobody can imagine the U.S. government will ever default, T-bills are accounted virtually risk free-at least, they carry no risk premium. Eurodollars, on the other hand, are dollar liabilities of banks outside the United States. They're not as liquid as T-bills, not as good of a credit risk, and are created and traded in an unregulated, uninsured market subject to blocking by foreign governments. (Remember when Jimmy Carter froze Iranian assets in U.S. banks?) Eurodollar CDs are only as good as the banks they represent. In the face of these higher risks, Eurodollar deposits must pay higher yields to attract depositors.
Changes in interest rates, whether caused by panic or inflation, tend to hit hardest on the short term sector where the maturities are shortest. Since both T-bills and Eurodollar CDs are short term instruments, the TED Spread benefits from a maximum fluctuation in rates.
The TED Spread is a confidence barometer. When there's no crisis brewing, the spread tends to narrow. When people fear financial crisis or war, the spread widens out. If you are in the right place at the right time, you stand to profit. In the last 30 years, the TED Spread has ranged from about 6.0 per cent (600 basis points or ticks) to almost zero. Within recent years the low has been about 20 basis points, and today it stands at about ***50 ticks***
***(Note-'50 ticks' is outdated info)***
TED Spread Lingo
BASIS POINT or TICK: Measure of movement in the Eurodollar and T-bill contracts. One percentage point move in yield equals 100 basis points or ticks, so a tick is 1/100 of a one percentage point move in interest rates.
EURODOLLAR: Dollars deposited outside the U.S. In the late '60s, American banks found they couldn't raise deposits through the domestic CD markets because of government interest rate ceilings. To avoid these restrictions, they offered higher yielding deposits in unrestricted overseas branches. Eurodollars are those unregulated, uninsured, unrestricted deposits in the international market.
EURODOLLAR CD: Certificates of Deposits in overseas banks payable in dollars. $1,000,000 worth is the basis of the Eurodollar Contract, ticker symbol ED. The futures contract for Eurodollar CDs forms half of the TED Spread, the contract for T-bills the other half.
LIBOR: London Interbank Offer Rate, the interest rate benchmark for the Eurodollar contract.
SPREAD: Buying and selling two related futures contracts at the same time, either the near-term and long-term contracts of a single commodity, or the same expiration months of different commodities. The latter spreads trade on fluctuating long-term relations between commodities, like the TED Spread or the Gold-Silver ratio.
T-BILL: U.S. government debt instrument that matures within one year. A $1,000,000 lot of T-bills is the basis of the T-bill futures contract, which forms half of the TED Spread. (The contract for Eurodollar CDs forms the other half.) Ticker symbol is TB.
T-BOND: U.S. Government debt instrument with maturities greater than 20 years.
T-NOTE: U.S. government debt instrument that matures within ten years.
TED SPREAD: The simultaneous purchase of a $1,000,000 futures contract for U.S. T-bills and sale of a $1,000,000 futures contract for Eurodollar CDs, or vice versa. When you buy the T-bills and sell the Eurodollars, you are long the spread, expecting crisis or rising interest rates. When you sell the T-bills and buy the Eurodollars, you are short the spread, expecting calm or falling interest rates.
What Does It Offer?
Unlike other hedges, the TED Spread works equally well against inflation or deflation, dollar weakness, stock market meltdown, military action in Europe or Asia, defaults in the banking and financial system, even brokerage house defaults. It insures you against all those threats, and hedges against market risks like changing interest or exchange rates.
Buying the TED Spread gives you a hedge even more sensitive than gold. If Lebed were to suddenly become the Russian president and you want to know what the markets really think, don't bother turning on the radio. Leave the TV alone. Put down the newspaper, and reach for your phone for a quote on the TED Spread. In a real panic, the TED could rise 100 points in ten minutes.
An Answer to Complacency
Disinterest in the TED Spread mirrors all-time high market complacency that has, as yet, failed to assess or discount a whole new generation of instabilities. For the January/February 1996 Foreign Affairs, Ethan Kapstein wrote an article about changes in regulating the global financial system. Its title perfectly expresses the present complacency across all markets: "Shockproof: The End of the Financial Crisis." According to Kapstein, our all-knowing central banks and government "wise men" have finally ushered in the Financial Millennium. "Over the past 20 years the leading economic powers have created a regulatory structure that has permitted the financial markets to continue toward globalization without the threat of systemic collapse."
Certainly the TED Spread has grown less volatile over the past 30 years. That can be interpreted two opposite ways: a new stability, or complacency. Either the markets are much more stable now, after 20 years of financial innovation and new risk management vehicles, or the markets are drugged by complacency from the last ten years' historically rare performance.
Panic After Panic
In 1974 the Bankhaus Herstatt crisis sent the spread soaring to its highest mark ever, 600 basis points (six percent). The inflation crisis of 1980 and gold's spike to $850 sent the TED over 500. In 1982, Italy's Bank Ambrosiano collapsed and Mexico announced it was suspending debt payments, setting off the Third World Debt Crisis. The TED spiked to 350. When Continental Illinois Bank fell in 1984, the TED surged 120 points. When the stock market dropped 500 points in 1987, the TED leapt from 60 basis points to over 250.
Banking and financial crises recur because, by definition, our fractional reserve banking system is a confidence game. By definition, it is bankrupt. Worse yet, the world's "money" is created out of thin air. Periodic panic comes as naturally to the world financial system as a march to the sea comes to lemmings.
Facing merciless and near universal mistrust, what could central bankers do? The Group of Ten industrial nations hammered out the Basle Concordat (1975) and the Basle Accord (1987). These aimed to prevent "systemic" panic by injecting liquidity when needed, and forcing international banks to strengthen their balance sheets.
Don't underestimate how precariously close to collapse the world's financial system came in the '70s and '80s. In the summer of 1982, Kapstein recounts, "One U.S. treasury official . . . at the annual [IMF and World Bank meeting] wrote that the atmosphere was 'almost universally morose. Fear was widespread that the world's banking system would collapse, bringing an implosion of credit, then trade, and ultimately an inevitable worldwide depression.' "
In hindsight, we recognize that such unalloyed gloominess reliably marked the top of the market for fear. The boom in financial assets-with its indispensable confidence in systemic stability-had already begun. Compare the early Eighties' pessimism to the Nineties' optimism and complacency. Today markets are smug, self-satisfied, and don't give a hoot about banking, monetary or market collapse. Today you couldn't find a pessimist with a metal detector if he had pockets full of iron filings.
More than a decade of exploding financial asset markets has lulled world investors into a complacency seldom before seen. What are the signs? Barings Bank, 233 years old, folds and the Bank of England does nothing. Daiwa Bank's New York office loses a billion bucks, and the market yawns. Mexico's peso collapses, and the stock and bond markets hardly bounce. Bad news or good news, the U.S. stock market just keeps on rising.
Perhaps another and even surer sign of incurable bubble-complacency is the very appearance of Kapstein's article "Shockproof: The End of Financial Crisis." Do I detect just a whiff of arrogance there? Why does it remind me of the Construction Superintendent on the Tower of Babel? Are our central bank "philosopher kings" really that clever? Has the Millennium really arrived, or are financial markets around the world simply dozing like Dracula's victims in a Grade B thriller?
Whether traps or treasures lie ahead, the TED Spread offers an inexpensive, long term hedge against all sorts of crises, not to mention market risks. Right now, it satisfies all the classical trade selection criteria, and stands behind nearly thirty years' weight of technical support. Let's take a closer look.
How It Works
The Chicago Mercantile Exchange (CME) trades futures contracts for Eurodollar CDs and U.S. Treasury bills. Both these contracts trade in $1,000,000 denominations. Like bonds, when the yields on these instruments rise, their value falls, and vice versa.
In our financial system, a panicking flight to quality means a flight to U.S. Treasury bills. Other things equal, panic will send T-bill prices up (yields down), while it sends Eurodollar prices down (and their yelds up). The spread between the T-bill yield and the Eurodollar yield widens out. We want to profit when Eurodollar yields rise compared to T-bill yields, so we buy the TED Spread. How? You "go long" (buy) the T-bill contract, and "go short" (sell) the Eurodollar contract at the same time. For every basis point the spread widens, you make $25.00 (and you lose $25.00 for every point the spread narrows). The margin requirement is only $235 per spread.
Since the Eurodollar market is fractional reserve banking gone rabid and foaming at the mouth, it is always a disaster waiting to happen. When the slightest whiff of scandal or political uncertainty wafts by, the spread typically doubles, then drifts back down as worries abate. Think of a plane load of people at 30,000 feet. One minute the passengers are laughing and relaxed, then comes the slightest bump, and the hidden fear fills the cabin like the bitter stench of death. That's the Euromarket.
Assume you bought the TED Spread at 50, and say, the Bosnians invade Serbia. Europeans and Americans panic, flee to T-bills, and Eurodollar CD rates climb 100 basis points. You would profit by $2,500 (100 basis points times $25), just over 425% on your $235 margin.
What if things really flew to pieces? What if the U.S. stock market melts down? The spread might explode back to 600 basis points, leaving you with a $13,750 return (550 points x $25).
What about the downside? In 1993 the TED Spread bottomed at the height of optimism about perestroika, privatization, and the bull market in bonds (falling interest rates). That peculiar conjunction of events isn't likely to line up again any time soon. Even in 1993 when the cash spread dropped near zero, TED Spread futures never dipped much below 20 basis points. The contracts traded on the CME (the ones you want to trade) are futures contracts, and almost always carry a premium for the remainder of their three- to six-month life. From where the spread stands today, around 50 basis points, your practical downside risk is about 30 basis points or $750.
Remember, too, that the TED Spread also hedges interest rates. Generally (or, to use the economist's famous alibi, other things being equal) the interest rates (along with the prices) on T-bills and Eurodollar CDs vary inversely. When one rises, the other falls. Generally, as the market level of interest rates rises, the spread widens out, and vice versa. It is this relation that makes the spread work as a chaos, crisis, and financial hedge.
Trading the TED
The sensitive TED Spread can insure you against stock market risk. For around $5,000 you can set up the most elegant portfolio hedge in the world, but you must have a knowledgeable broker who understands the spread and pays close attention to the market. His timely attention will stack the odds in your favor so that you can ride this spread at nearly no cost. Best of all, the TED lies outside the arena of stock markets and their derivatives. Even if a trading holiday closed the stock market and its hedges, the TED Spread would remain open. About every six months your TED Spread contracts will expire, and you'll have to roll them forward. However, this only requires a few simple instructions to your broker-and you'll always want to stay long the spread.
Even If You Don't Buy It . . .
You ought to watch the TED Spread constantly because it is the insiders' best early warning radar. The TED Spread is where the world's risk managers are moving their money, and the best part is, they can't do it without leaving tracks. What are central bankers doing? Big banks? Investment bankers? Conglomerates? Corporations? Really wealthy individuals? Follow their spoor across the TED Spread.
The TED Spread also furnishes a valuable indicator for precious metals investors. When crisis talk is brewing but the TED remains quiet, gold investors should have second thoughts before acting. On the other hand, when the TED starts moving above say, 75, it could mean that smart money in Europe and the Far East already smells something bad coming down the pike, and they're runnng away early, before the general public catches on.
The TED Spread offers both the ultimate portfolio hedge and the ultimate crisis indicator. Best of all, this important tool has been all but forgotten in the last six to ten years. In virtually every large portfolio today, the biggest missing link is an ongoing TED Spread component. Usually a tool this flexible would only be available to institutions or the extremely wealthy, but even the most modest investor can fully capitalize on the TED Spread.
TED Versus Gold
What about the TED and gold? Right now, the TED is bottoming and beginning a minor upside probe, as if suspicious noses were snuffing something on the wind. This confirms and strengthens the current upside potential in gold, and downside threat in the toppy U.S. dollar.
The political instabilities now just rearing their heads remind me of the gold market in 1971, and like gold, you can't buy after the TED takes off. Technically the TED has completed a 25 year trend and formed a large saucer bottom in the last five years of complacency. Now is the time to put it on.
Markets Are Not Efficient
In spite of economic dogmas to the contrary, markets are not always efficient, and never in the short term. If they were, nobody could make a profit. Every player doesn't know every thing at the same time, so markets can only evaluate risk correctly over time. Right now, the wide spread and easy successes of runaway bulls in stocks and bonds have lulled markets to sleep. They are inefficiently assessing geopolitical, financial, banking, and stock market risks. Right now-before everyone starts running for the doors-is the time to hedge your success with a TED Spread. It's a small price to pay for big protection.
Note:
You cannot buy TED Spreads through a stockbroker. Because the contracts are listed on a commodity exchange, you'll need a commodity account. |
