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TED on FRED

There are many TEDs, but the TED in FRED is a spread. That is, the spread between the 3-month LIBOR and the 3-month Treasury bill.

A little background: LIBOR is the rate banks would charge each other for lending, which can be used to measure economy-wide credit risk. Treasuries are basically the safest assets on the market. So, a large TED spread would indicate a lot of credit risk in the U.S. economy.*

But how large is a typical TED spread? At the time of this writing, it looks like it’s about 30 to 40 basis points (0.3 to 0.4%), which is mid-range for recent years. It was up to 57 basis points in 2012 and below 20 on several occasions. A longer historical perspective shows that in times of crisis the TED spread really rises. Use the slider below the graph to change your sample period: The October 1987 stock market crash raised TED spreads close to 300 basis points, and the financial crisis of 2008 raised them to 450 basis points. Considering the whole sample, current conditions actually look pretty good.

*A side note: The TED spread is always going to be positive unless the risk on Treasuries increases much more than what current credit conditions warrant. This scenario could be caused by an increased risk of (partial) default by the U.S. government while credit conditions for U.S. banks remain unchanged. That’s unlikely to happen.

How this graph was created: Search for “TED spread” and you have your graph.

Suggested by Christian Zimmermann

View on FRED, series used in this post: TEDRATE

Dating the financial crisis using fixed income market yield spreads

How would you answer the question, “When did the Great Financial Crisis begin?” Some date the beginning of the crisis according to the events surrounding the failure of Lehman Brothers in mid-September 2008. But at that point, financial markets had already been in turmoil for more than a year, as certain time series from the summer of 2007 show. So how do you date the crisis?

One way to date the recent financial crisis is to identify significant breaks in the dynamics of yield spreads from U.S. fixed income markets (thought to be at the core of the crisis) using appropriate statistical techniques, like I do in a forthcoming article (working paper version) along with coauthors Massimo Guidolin and Pierangelo De Pace. With a particular definition of financial crisis in mind, this procedure allows us to identify the weeks of August 3, 2007, and June 26, 2009, as the beginning and the end of the crisis, at least from the perspective of fixed income yield spreads.

While some of the spreads we use are based on proprietary data, several can be constructed from FRED data. In the graph, we plot the spread between Moody’s seasoned Aaa corporate bond yield and Moody’s seasoned Baa corporate bond yield, as well as the spread between the 30-year fixed-rate mortgage average in the United States and the 30-year Treasury constant maturity rate.

Even just eyeballing the graph gives a sense of the degree of comovement of these spreads at least for the period beginning in 2007. Moreover, the spreads show an upward shift in their level approximately in the second half of 2007 as well as a downward shift approximately in mid-2009.

How this graph was created: In FRED, enter “Moody’s” in the search box. This will return a few Moody’s series: I first selected the Baa corporate bond yield and then added the Aaa corporate bond yield. The spread is then the difference between the two: a-b. A similar transformation was applied to the 30-year Treasury constant maturity rate and the 30-year fixed-rate mortgage average in the United States.

Suggested by Silvio Contessi

View on FRED, series used in this post: AAA, BAA, DGS30, MORTGAGE30US

The St. Louis Fed’s Financial Stress Index, version 3.0

In 2010, the St. Louis Fed introduced its St. Louis Financial Stress Index (STLFSI), which quantifies financial stress in the U.S. economy using 18 key indicators of financial market conditions—7 interest rates, 6 yield spreads, and 5 other indicators. This index, of course, can be found in FRED.

The STLFSI uses principal component analysis (PCA) to calculate the “factors” most responsible for the co-movement of several variables. By relying on multiple types of indicators, the STLFSI captures a broad, robust concept of overall financial stress. Just last year, we slightly revised the index’s methodology (creating the “STLFSI 2.0” or “STLFSI2”) to account for trends in several of the series. We’ll be revising the index again, and this post describes the motivations and details of this revision.

The London Interbank Offering Rate, or LIBOR, measures the average interest rate at which major banks lend to each other short-term, unsecured (i.e., non-collateralized) loans. Lending to another private institution always has the risk that the institution will be unable to repay its loans, and the spread between the LIBOR and “riskless” interest rates over the same period helps quantify financial credit market risk. An increase in credit risk, all else equal, will increase the STLFSI.

Two of the indicators used in the STLFSI rely on the LIBOR: the yield difference (“spread”) between the 3-month LIBOR and the overnight index swap (the LIBOR-OIS spread) and the spread between the 3-month Treasury bill and the 3-month LIBOR (the TED spread).

But, starting this year, the LIBOR is being slowly discontinued, and Fed officials have encouraged the use of alternative measures in the meantime.* So, we are revising the STLFSI to account for this change.

Many rates have been suggested by regulators and market participants as a replacement. We, like many, have decided to replace LIBOR with the secured overnight financing rate (SOFR), which tracks the cost of short-term borrowing using transaction data on loans—collateralized by U.S. Treasury securities—in the overnight repo market. Proponents of the SOFR—including the Federal Reserve Bank of New York—argue it is a more accurate measure of bank borrowing costs than the LIBOR. The 90-day average SOFR also closely tracks the 3-month LIBOR.

One difference is that the LIBOR covers unsecured loans, while the SOFR covers secured loans (collateralized with Treasuries). Credit risk matters less in the latter case since the lender receives collateral if the borrower doesn’t pay back the loan. We see this in the graph above, where the SOFR tends to be lower than the LIBOR—reflecting the smaller risk of collateralized lending (and, thus, cost of borrowing). Nonetheless, its movements likely capture some information on changing credit risk since lenders prefer liquid cash over illiquid collateral—as evidenced by the SOFR’s co-movement with LIBOR.

A challenge in switching from LIBOR to SOFR is that the latter has a much smaller number of observations—it begins in 2018. We decided on a simple fix: We estimate what past SOFR spreads would have been, based on the LIBOR rate each day. We do this by calculating simple linear regressions that regress the SOFR spreads on their LIBOR counterparts, using average weekly observations from the SOFR’s introduction through the end of 2021, and use the regression’s estimates in our new STLFSI calculation for the years before the SOFR was introduced.

For the past several weeks, we have been tracking the new STLFSI (3.0) and comparing it with the STLFSI 2.0. As seen in the graph below, the correlation between STLFSI 2.0 and 3.0 is very high, about 0.99.

Still, there are some small but notable differences between the two indices. The biggest period of divergence is the first year or so after the SOFR was introduced (2018-19)—which makes sense, since (as we saw in our first graph) the SOFR initially did not track the LIBOR as closely as it has more recently. More interestingly, the STLFSI 2.0 tended to be slightly higher than the STLFSI 3.0 during the Great Recession, whereas the STLFSI 3.0 has tended to be higher than the STLFSI 2.0 during the COVID pandemic; indeed, it has been consistently about 0.05 index points higher than the STLFSI2 in the last year. Despite these differences, the two indices nonetheless provide consistent signals of above- or below-average financial market stress, with few occasions where one is positive and the other negative. Thus, we are confident that the new STLFSI will continue to serve as a reliable indicator for monitoring financial conditions.

* Former Federal Reserve Governor Randall Quarles noted in a speech last year that the LIBOR would not be available for any new contracts beginning in 2022. Governor Quarles also said that the Fed and other regulators sent a letter to banking organizations they oversee stating that “after 2021, the use of LIBOR in new transactions would pose safety and soundness risks.” These supervised institutions were “encouraged” to seek out an alternative reference rate for new contracts beginning on January 1, 2022. As we discussed above, the recommended alternative reference rate is the SOFR.

Why are the Fed and other regulatory institutions urging financial institutions to discontinue the use of LIBOR? As Governor Quarles and others noted, years after the STLFSI’s release, regulators have highlighted LIBOR’s shortcomings over several years. Quarles stated:

The principal problem with LIBOR is that it was not what it purported to be. It claimed to be a measure of the cost of bank funding in the London money markets, but over time it became more of an arbitrary and sometimes self-interested announcement of what banks simply wished to charge for funds.

How these graphs were created: For the first graph, just search for the St. Louis Financial Stress Index and select the series that is not discontinued. For the second graph, search for “90-day SOFR”: From the “Edit Graph” panel, use the “Add Line” tab to and search for and select “3-month LIBOR.” For the third graph, take the first and add a line searching for “STLFSI2.”

Suggested by Aaron J. Amburgey, Kevin L. Kliesen, Michael W. McCracken, and Devin Werner.



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