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Interest Rate Spreads.  A Predictor of Future Market Moves? Thumbnail

Interest Rate Spreads. A Predictor of Future Market Moves?

Professional poker players are very good at reading “tells”, especially from amateurs.  “Tells” are subtle (and often unconscious) giveaways to whether a player is bluffing or really has a good hand,  For example, players can telegraph their hands by blinking a lot, looking up at the ceiling, sitting back in their chair, tensing their jaw muscles, and any of hundreds of other tics and actions.  Markets too have their subtle ways of signaling investors about their true nature.

Information in markets makes its presence felt first in the most liquid arenas.  The most highly traded and liquid products act like canaries in a coal mine, sensing the poisons seeping into the markets before many are even aware of pending trouble.  The most sensitive canaries in the financial world are interest rates.  One important barometer of economic health is the spread between LIBOR (interbank lending rates, which drive institutional and corporate rates) and U.S. Treasuries, particularly at the (very liquid) 3-month maturity (the so-called “TED Spread”).  When this spread is narrow, financial markets are generally calm as investors are not demanding that (credit-exposed) banks pay much higher interest rates on short-term deposits than the U.S. Government does.  Widening of the spread, however, indicates stress as investors flee (risky) banks for the safety of (risk-free) government securities (aka “flight to safety”).

As the chart shows, sometimes this “flight” is rapid and chaotic as spreads blowout, like they did last March when the COVID crisis suddenly emerged, with the equity markets dropping quickly thereafter or almost simultaneously.  Many times, however, when there isn’t such an obvious catalyst as the pandemic, the spread starts moving long before other markets do.  The 2008-09 financial crisis is a good example.  The S&P 500 rose in the first 3 quarters of 2007 before beginning a 6-quarter losing streak that took it down more than 50%.  However, the TED spread began to widen in February 2007 and jumped late that summer while it was still “party-on” on Wall Street – the canary was dying, and no one noticed!

So far this year, while longer-term rates (like the 10-year U.S. Treasury yield) have been rising, perhaps on inflation fears given massive government spending (a topic for another day), the TED has been quiet, giving investors some comfort and in line with BWC’s cautious bullish advice.  We are never warned so bluntly as Shakespeare’s Caesar, but minding the canary might give us an early “tell” about the stock market.

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