'Inversion' in Bond Rates Hits Stocks

By Tom Petruno

Dec. 28, 2005 12 AM PT

Times Staff Writer

Blue-chip stocks on Tuesday suffered their steepest decline in two months, as falling long-term Treasury bond yields flashed a classic warning sign of a weaker economy ahead.

Holiday retail sales reports also left some investors unimpressed.

The Dow Jones industrial average gave up a 50-point rally early in the day to end down 105.50 points, or 1%, at 10,777.77. It was the Dow’s worst one-day slump since Oct. 27 and pushed the widely watched index back into the red for the year.

Broader gauges also were down sharply, dashing hopes for the traditional “Santa Claus rally” in the final week of the year.

What worried some investors and traders Tuesday was a relatively rare occurrence in the bond market: The yield, or interest rate, on the bellwether 10-year Treasury note declined to a level that equaled or was slightly below yields on shorter-term Treasury securities.

Normally, longer-term bonds pay more than shorter-term issues to compensate investors for the risk of tying up their money for an extended period.

When long- and short-term interest rates converge, it often is a sign that bond investors believe the economy will slow -- so they’re locking in long-term yields in anticipation that rates overall soon will level off or even head lower.

“We should be worried” about the economy, said Michael Cheah, who manages $2 billion in bond assets at AIG SunAmerica Asset Management in Jersey City, N.J.

The 10-year T-note yield, a benchmark for mortgages and other long-term rates, ended at 4.34% on Tuesday, down from 4.37% on Friday and the lowest since Sept. 30.

By comparison, the Treasury sold new six-month bills at an annualized yield of 4.35% on Tuesday. And the two-year T-note ended at 4.34%, down from 4.36% on Friday.

Although the difference between short- and long-term rates has been narrowing for weeks, Tuesday’s trading session marked the first time in five years that the 10-year T-note yield ended below the six-month T-bill yield. In Wall Street parlance, that is known as an interest rate inversion.

The last time rates inverted was in the second half of 2000. By spring of 2001, the U.S. economy was in recession.

On Wall Street, that memory was enough to push some investors to sell stocks Tuesday, said Michael Metz, chief investment strategist at money management firm Oppenheimer Holdings in New York.

And because trading was fairly thin in the first session after the Christmas holiday, it didn’t take much to move share prices, he said. Some sellers “were throwing in the towel, but there was nobody to throw the towel to,” Metz said.

The stock market’s concern, of course, is that an economic slowdown could hurt corporate earnings and undermine share prices in 2006.

But many economists and money managers say they don’t believe the trend in bond yields is foreshadowing a significant deceleration in the economy.

Indeed, Federal Reserve Chairman Alan Greenspan has said that the central bank did not believe that a convergence of interest rates would be a recession warning, as has usually been the case in recent decades.

This time, other forces may be pulling longer-term rates lower even as the Fed pushes short-term rates higher, analysts say. For example, the record demand this year for U.S. bonds by foreign investors, particularly in booming Asia, has helped to restrain bond yields, many say.

Donald Quigley, a bond fund manager at Julius Baer Investment Management in New York, said he agreed that foreign demand for U.S. bonds was a factor in driving yields lower.

Nonetheless, he said, investors who are willing to accept lower yields on long-term bonds than on short-term securities also must believe that the economy -- and inflation -- are more likely to weaken than to resurge.

“It certainly doesn’t say growth is going to be gangbusters,” Quigley said of the rate inversion.

AIG SunAmerica’s Cheah said he was more pessimistic about the economy because he worried about the effects of a rate inversion on the housing market. Banks, he said, may no longer find it profitable enough to make long-term loans such as conventional mortgages.

“I’m betting that ... many banks will stop lending to the housing market,” triggering broader economic weakness, he said.

Mixed reports Tuesday on holiday sales, both before Christmas and for the post-Christmas shopping rush Monday, also raised concerns about the economy, analysts said. Michael Niemira, economist at the International Council of Shopping Centers, told Bloomberg News that retailers had a “C-plus” holiday season.

Shares of online closeout retailer Overstock.com sank $2.49 to $31.15 on Tuesday after the company said its fourth-quarter sales growth would be “two times the industry average rather than the three to four times that the company had posted in the past.”

Among the day’s highlights:

* Losers topped winners by more than 2 to 1 on the New York Stock Exchange and on Nasdaq. The Standard & Poor’s 500 index slid 12.12 points, or 1%, to 1,256.54. The technology-heavy Nasdaq composite fell 22.53 points, or 1%, to 2,226.89.

* Indexes of smaller stocks suffered bigger losses than blue-chip indexes, retreating further from record highs reached early this month. The Russell 2,000 index of smaller issues dropped 9.86 points, or 1.4%, to 676.58. It is down 2% since reaching an all-time high Dec. 2.

* In the retail sector, Federated Department Stores lost $1.28 to $64.97, Nordstrom lost 70 cents to $36.81 and Coach was down 82 cents to $32.58. But Kohl’s gained 54 cents to $49.24; Target added 7 cents to $55.58.

* A drop in oil and natural gas prices failed to cheer the broader market, and may have hurt it by pulling energy-related stocks down sharply. Marathon Oil slumped $2.20 to $59.96, Schlumberger sank $3.05 to $97.10 and Apache dropped $2.77 to $67.54.

* Gold continued to rebound from recent profit taking. Near-term futures in New York rallied $5 to $508 an ounce. Gold hit a 24-year high of $528.40 on Dec. 12.

* European stock markets were higher, adding to what have been strong gains for most of this year. Germany’s DAX index rose 25.79 points, or 0.5%, to 5,444.84, its highest closing level since March 2002. The index is up 27.9% in euros this year.

The French CAC index rose 0.2% to 4,769.38, the highest since mid-2001. It’s up 24.8% this year.

Japan’s Nikkei-225 index fell 0.9% to 15,969.40 after reaching a five-year high Monday. The Nikkei is up 39% in yen this year.

By contrast, the U.S. S&P; 500 is up 3.7% and the Nasdaq composite is up 2.4%. The Dow is down 0.1%, although it is up 2.3% with dividends included.

If U.S. stocks fail to advance in the next few days, it could set a poor tone for the new year, according to the Santa Claus-rally indicator. Since 1969, the S&P; 500 has gained an average of 1.6% in the last five trading days of the year and the first two trading days of the new year, according to the Stock Trader’s Almanac.

“Santa’s failure to show tends to precede bear markets,” or at least “much lower” stock prices at some point later in the year, the almanac says.

(BEGIN TEXT OF INFOBOX)

Flat yields in the bond market

Short- and long-term Treasury yields, far apart a year ago, are now nearly the same.

Annualized yield on Treasury securities

6-month

Year ago: 2.59%

Tuesday: 4.35%

2-Year

Year ago: 3.06%

Tuesday: 4.34%

3-year