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Datawatch

History shows that Asia should not rejoice in US stock rally

Inverted yield curve is often followed by market crashes

Long-term U.S. Treasury rates have stayed lower than short-term rates recently. 

TOKYO/NEW YORK -- Analysts are warning that despite U.S. blue chips soaring to historic highs, the inversion of the U.S. Treasury yield curve points to a looming recession.

An analysis of data over the past 60 years shows that U.S. stock prices typically rose an average 29% following the inversion of the Treasury yield curve, or when short-term interest rates became higher than long-term rates, before slumping in tandem with an economic slowdown.

Although the Dow Jones Industrial Average, which tracks 30 stocks, closed above 27,000 for the first time on Thursday, Byron Wien, vice chairman at private equity Blackstone Group, said he saw more equity upside.

His comment was not without reason. Jerome Powell, chairman of the U.S. Federal Reserve, hinted Wednesday at a possible rate cut later this month, adding fuel to expectations that stock prices will remain high despite an economic slowdown thanks to the U.S. central bank's easy monetary policy.

In Asia, stocks have also been rebounding. The Shanghai Stock Exchange Composite Index has risen 20% since the start of this year, while Hong Kong, Thailand and Vietnam bourses have climbed roughly 10% in the same period.

Yet, long-term interest rates have stayed lower than short-term rates. The yield on three-month U.S. Treasury notes stands at 2.14%, above the 1.8% range for two-year and five-year bills.

Typically, long-term rates are higher as they factor in greater risks as a result of longer exposures. Analysts said the reason for the inverted yield curve is that the U.S. economy has been expanding since July 2009, in the aftermath of the financial crisis. That growth has now entered its 11th year, the longest stretch since the 1850s when records began.

In this scenario, with worries that economic growth is nearing its end, investors tend to pick up bonds with longer maturities. As demand for these bonds increase, their prices also rise, leading to a fall in yields. In the meantime, central banks had been keeping interest rates relatively high, as the Fed has done, until last year. Such developments lead to the inversion of the yield curve.

Inverted yield curves tend to have an adverse effect on banks, which rely on raising money in the short term and lending over the longer term. Even as the broader market reaches new highs, the S&P financials index remains shy of its 2007 record.

"For the yield curve to cause a downturn, it would have to have a direct link to the economy," Michelle Meyer, a Bank of America Merrill Lynch economist for the U.S., said in a report in July. "Presumably, this would be through tighter credit conditions... in theory, the inverted yield curve would make it less attractive for banks to extend credit."

Since the beginning of the year, three-month, six-month and one-year notes at times have had higher yields than 10-year Treasuries. And the spread between two-year and 10-year Treasuries, a closely watched hallmark of an inverted yield curve, has narrowed to 28 basis points.

This is a consistent trend. Historical records show that following the Asian financial crisis in 1998, the Fed embarked on a cycle of moderate rate cuts. Stocks then rose more than 40% to a peak before the bursting of the IT bubble in 2001, which triggered the next recession. When Treasury yield curves inverted after 2005 before the global financial crisis, stocks rose nearly 30%.

"An inverted yield curve occurs when expectations of an end to interest rate hikes and start of rate cuts increase before a descent begins," said Daiju Aoki, chief investment officer for Japan at UBS Wealth Management.

The worry now is that stock prices will crash as the real economy suffers. Of the six times that the yield curve had inverted, five resulted in stock price plunges of 10% to 50%.

Japan and Europe have experienced the drama. In Japan, the Nikkei Stock Average surged to a record high in late 1989 after short-term interest rates exceeded long-term rates, but then plunged when the economic bubble burst. In Germany in 2007 before the global financial crisis, stocks rose then fell after the gap between long- and short-term interest rates narrowed to zero.

A survey by Invesco, an American asset management company, found that 90% of the world's sovereign wealth funds are cutting back on the allocation of assets to equities as they expect the economic cycle to reverse within two years.

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