Wednesday, July 21, 2010

System Risk Ebbing, For Now

One of the differences between the latest correction and previous market setbacks in this bull market has been the return of system risk. Many of the system risk indicators we follow are bond market relationships and we have written about them in this blog from time to time. One of those measures is called the TED Spread. The TED spread is the price difference between U.S. T-bill futures contract and Eurodollar futures for an identical expiration. It is used as a credit risk indicator since the market currently deems T-bills to be “risk free,” while the Eurodollar market is assumed to be more like corporate credit due to the less stringent regulatory environment overseas.

During the height of the current correction the TED spread was rising as European banks came under pressure, causing fresh strains in the interbank lending market. More recently, it is encouraging to see the TED spread drifting lower, along with a decline in the price of credit default swaps and corporate spreads in general. Risks are not all equal, and the risk of another banking freeze is not to be ignored. For now, there are some positive signs that things are calming somewhat in credit markets. But this pause is a not a guarantee that credit flare ups are over, and we’ll have to keep a very close eye on the TED spread and other measures of system risk over the coming weeks and months ahead.

Chart: 6-month TED spread (source: Bloomberg)