Sunday, January 18, 2009

Reality Check - TIPS, TED, and VIX

TED spread is the interest rate difference between three month futures contracts for LIBOR (rate charged by banks on each other for three-month loans in dollars) and US T-Bills. It is a measure of credit risk in the money markets which represents the fear in the banking system. A high TED spread indicates increased default risk, and reflects higher borrowing cost for banks. During the height of the credit squeeze in October-November 2008, the TED had become "the consensus indicator of the depth of the current financial crunch". A long term perspective of the TED is available here. The latest TED spread values are available here.

TED spreads have declined as dramatically in recent weeks as it rose from early September of last year. After touching 4.6% on October 10, 2008, when inter-bank lending almost frooze, the TED has fallen to 0.98% by January 13, 2009. This indicates the relative calmness that has been restored in the credit markets, especially the market for Commercial Paper (CP). At its lowest, the TED spread can be as low as 20 basis points, as it was in early 2007.

Felix Salmon draws attention to a plausible reason for this steep decline. The flooding of the banking sector with liquidity through direct cash injections and by opening unlimited auction windows by Central Banks across the world, may have contributed to the steep fall in the TED spread. With so much liquidity available, banks have evidently had limited incentive in approaching the 3-month LIBOR for funds. Further, since inter-bank lending has dried up, any TED spread figure is likely to be a misleading figure. All this in turn means that the low TED spreads are no indicator of any proportionate decrease in credit risks.

Treasury Inflation Protected Securities (TIPS) are inflation indexed bonds issued by the US Treasury, whose principal is adjusted to the Consumer Price Index (CPI), the common measure of inflation. By comparing the difference in coupon values of TIPS bond with a standard nominal Treasury bond across the same maturity dates, we can have a measure of the bond markets expected inflation rate.

And as the latest spreads show, the news on this is not encouraging, with the spread being almost zero, indicating deflationary expectations. In fact, the TIPS spreads have been converging sharply over the last quarter of 2008.

VIX is the Chicago Board Options Exchange Volatility Index, which measures the implied volatility of S&P 500 index options for 30 day period, by using a weighted blend of prices for a range of options on the index. Assuming S&P 500 is broad measure of the equity markets, a high VIX corresponds to greater volatility. The VIX, often called the "fear index" or "investor fear gauge", is quoted in terms of percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, on an annualized basis. VIX values above 30 indicates large amount of equity market volatility.

The latest VIX of 46.1 is indicative of the high volatility associated with the equity markets. However, on the positive side, it has been on the decline, after reaching alarmingly high figure of around 90.

As the three indicators show, the VIX and TIPS spreads are causes for continuing concern, while the decline in TED may be attributed more to the unprecedented actions of the Central Banks than any actual lowering of credit risks.

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