Two major risk indicators—the TED and LIBOR-OIS spreads (see further explanations below)—are steadily reaching new highs as the potential fallout for U.S. banks from Europe and elsewhere increases. Although U.S. economic data has been improving, it will be very difficult to see any meaningful improvement in the stock market until these indicators reflect reduced fears over lending and economic conditions by major banks in the financial system.
TED Spread
The TED spread is an indicator of perceived credit risk in the general economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. When the TED spread increases, that is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders, therefore, demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the TED spread decreases. (source)
(emphasis mine)
LIBOR-OIS Spread
Three-month LIBOR is generally a floating rate of financing, which fluctuates depending on how risky a lending bank feels about a borrowing bank. The OIS is a swap derived from the overnight rate, which is generally fixed by the local central bank. The OIS allows LIBOR-based banks to borrow at a fixed rate of interest over the same period. In the United States, the spread is based on the LIBOR Eurodollar rate and the Federal Reserve's Fed Funds rate.
LIBOR is risky in the sense that the lending bank loans cash to the borrowing bank, and the OIS is stable in the sense that both counterparties only swap the floating rate of interest for the fixed rate of interest. The spread between the two is, therefore, a measure of how likely borrowing banks will default. This reflects counterparty credit risk premiums in contrast to liquidity risk premiums. (Source)
(emphasis mine)
