Editor's Note: This is the first part in a series of articles monitoring financial sector spreads in order to give an accurate, up-to-date picture of the credit crisis.

For the world’s financial system to start functioning normally again, it's imperative that confidence in the credit markets be restored. In order to gauge the progress being made to unclog credit markets, I regularly monitor a range of financial sector spreads and other measures.

By perusing these, one can ascertain to what extent the various central bank liquidity facilities and capital injections are having the desired effect.

I plan to update this “credit crisis watch” regularly, as I believe a grip on the credit situation will be key to determining the appropriate investment strategy.

First up is the 3-month dollar LIBOR rate. After having peaked on October 10 at 4.82%, the rate declined sharply to 2.13% on November 12, but the healing process has since experienced a setback with the rate edging up to 2.18%. LIBOR trades at 118 basis points above the Fed’s target rate of 1.0%, compared with 43 basis points at the start of the year.


Source: StockCharts.com

Importantly, the US 3-month Treasury Bills are trading at a minuscule 0.071%, indicating that liquidity is still being hoarded.

US Three-Month Treasury Bill Rate

Click to enlarge
Source: The Wall Street Journal

The TED spread (i.e. 3-month dollar LIBOR less three-month Treasury Bills) is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. On the other hand, when the risk of bank defaults is considered to be decreasing, the TED spread narrows.