If you’re like me, you’ve been watching the stock market bounce around like a yo-yo for the past couple of weeks and hoping it gives you some kind of indicator as to how the financial crisis is shaping up. And, if you’re like me, you’ve been unable to glean even a tiny bit of information from its gyrations. As I learned today, the stock market is the wrong thing to watch. It’s just reacting to something else: the frozen credit markets.
So how do we watch those? Well, the wonderfully informative people at NPR’s Planet Money podcast point us to the right place. The core of the crisis is that people don’t want to lend to each other. This is the same thing that happened prior to the Great Depression, and our lack of response to that credit freeze may be what turned a financial downturn into a global depression. When the solvency of institutions that are supposed to be stable, like banks, comes into question it makes people timid with their investments. In fact, it even makes banks afraid to lend to each other, and that’s when things get really ugly.
So there are two things to watch.
The first is the rate on 3 Month Treasury Bonds. These are considered very safe investments, so when people panic, the put their money here. And the more money the put into them, the less of a return they pay. What does that mean?
As the market panics, the 3 Month Treasury rate goes down. As it calms, it goes back up. Right now the rate is .11% Last month it was at 1.58%. Not so good.
The second thing to look at is something called the TED Spread. The TED Spread is basically the difference between the rate on one of those 3 Month Treasury Bonds and the rate banks are actually charging each other to borrow money. The lower the TED Spread, the more confident banks are in each other. Why? Because if you think someone is safe, you’ll charge them close to the same interest you’re getting out of the really safe government treasury bonds. If not, you’ll charge them a lot more, because those T-Bills are way less of a risk. A good explanation of this can be found here.
So historically the TED Spread has been at around .5%. It went up to 1% for most of this year, which you can see on the chart at Bloomberg.com which I linked to above. Then things got bad. Now the TED is hovering around 4.5%, and is not yet going down. That means that even though we’ve dumped some money at the problem, banks still see each other as risky investments and are reluctant to give them money.
As the stock market flies all over the place, keep your eyes on Treasury bonds and on the TED Spread to see if the real cause of this crisis – frozen credit – is getting better.
So far it isn’t.