Bond Market Sparks Recession Fears Plunging Dow

Wall Street's December rally reversed course dramatically today after developments in the bond market heightened fears of a recession ahead.

Defying the usual rule that investors can earn higher interest rates on longer-term bonds, rates in the New York bond market on two-year and 10-year Treasury bonds were exactly the same -- 4.374 percent -- for a time today.

And in overseas markets, some short-term bonds were paying higher interest rates than the longer-term bonds -- a phenomenon that often forecasts a recession.

The Dow Jones industrial average suffered its worst loss in two months falling 105.5 points to 10,777.77.

The Standard & Poor's 500 stock index skidded 12 points to 1,256.54.

The Nasdaq Stock Market composite index dropped almost 23 points to 2,226.89.

The markets also were hurt by warm weather, which cooled off prices of natural gas and other fuels and in turn took down the stocks of energy companies. In the energy futures market, the price of natural gas to be delivered next month dropped 9 percent as much of the nation basked in unseasonably temperature.

But the weather-induced gyrations of energy prices are only a short-term influence on stock prices compared to the longer term threat posed by what's happening to interest rates.

Today's activity was a rare reversal of the standard pattern. The past four recessions in the United States occurred after long-term bonds were paying lower interest rates than short-term ones.

Ordinarily the pattern of interest rates is the longer the time to repay the debt, the higher the rate. Because there is more risk in holding an investment for 10 years than for two, a graph of interest rates usually shows a line that start out low and gradually curves higher over time. Economists call that graph the "yield curve."

Today, however, the yield curve went away. It was for all practical purposes flat at the end of the regular trading session with two-year bonds paying 4.343 percent and 10-year bonds -- 4.349 percent.

Economists start to worry when the yield curve goes flat or flips over--"inverts" is the technical term.

When two-year and 10-year bonds are paying the same rate, it means investors think there is just as much risk in making a short-term investment as in making a long-term commitment. Inverted yields means traders think the two-year bond is actually a greater risk than the 10-year one.

The gap between long- and short-term rates has been getting smaller ever since the Federal Reserve started boosting short-term rates more than a year ago. The Fed has the power to order U.S. banks to raise short-term rates, but has no authority over longer rates. They are determined by what bond buyers -- in the United States and around the world -- are willing to take for a long-term investment.

At this point in time, there are plenty of investors willing to buy 10-year bonds paying a little more than 4 percent. But not as many are interested in two-year bonds. If the economy slows down, interest rates will likely be lower two years from now. Investors figure they are better off locking in rates for the next decade than taking the risk that they'll have to settle for lower rates after a couple of years.

Today's brief inversion in yields was not enough for economists to proclaim a recession is in the forecast, but it sure threw a scare into the market.