The TED Spread and Equity Returns

I was curious to see if there’s a connection between the TED Spread and equity returns. The answer seems to be no, but there are some notable exceptions. That’s one of the issues in doing research—you spend a lot of time crunching the numbers only to reach a dead end. Still, I thought I’d share my results with you.

The TED Spread got a lot of attention during the financial crisis and it’s faded away since then. The TED Spread is the difference between the short-term Treasury yield and the Eurodollar yield (TED standing for Treasury-Eurodollar).

In short, this measures the level of panic within the financial system. For the most part, the TED Spread bounces between 0.1% and 0.5%. When folks get nervous, it spikes up to 0.7% and can even go as high as 1%. During the financial crisis, it spiked over 2% and got as high as 4.58%. That shows you just how scary those days were.

I went to the Federal Reserve’s database and took all the TED Spread numbers going back to 1986 and compared them with the Wilshire 5000 Total Return Index. I then divided the Ted Spread numbers into 10 buckets of increasing value (0.09% to 0.2%, 0.21% to 0.25%, etc.). I then saw how the market performed on those days, and I annualized those results.

Here’s what I got.

Low Range Upper Range Count Return
0.09% 0.20% 933 10.11%
0.21% 0.25% 900 11.02%
0.26% 0.35% 801 16.12%
0.36% 0.50% 1,221 4.52%
0.51% 0.60% 763 9.46%
0.61% 0.85% 1,200 13.35%
0.86% 1.00% 411 9.46%
1.01% 1.40% 681 26.86%
1.41% 2.00% 303 26.01%
2.10% 4.58% 110 -59.52%

In other words, the Ted Spread was between 0.09% and 0.20% 933 times. Over that period, the market had an annualized return of 10.11%.

There doesn’t appear to be any clear trend until we exceed 1%. The stock market does very poorly over 2.10%, but that doesn’t happen often. Interestingly, the market does quite well between 1% and 2.10%.

My hunch is that that reflects the market chilling out as the TED Spread falls from its elevated position. For example, the TED Spread was still quite high after the 1987 crash. At the market low in March 2009, the TED Spread was still over 1%. This means it may not be the TED Spread itself that’s important to the stock market, but the direction of the TED Spread. Of course, that’s a guess (and for another project).

Whenever I do research like this, I want to find a variable that has a consistent impact on stocks. For example, I found that stocks do well when the 10-year TIPs yield is low. The lower the better, and the higher the worse. Those are the types of relationships I want to find.

Posted by on November 11th, 2015 at 11:54 am


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