Jobs Report Bolsters Market's Bullish View

Friday's jobs report is just the latest data showing this resilient economy has recovered faster than anyone expected. In response, the fixed-income market has begun to lay heavy odds on a fed funds rate hike by May -- a notion that economists scoff at, but that investors should seriously consider.

The unemployment rate dipped to 5.5% last month, from 5.6% in January. Economists had forecast it would rise to 5.8%. Payrolls increased by 66,000 against expectations they would stay flat. The good news on the jobs front comes on top of the recent jump in the February purchasing managers' indexes, the big upward revision to fourth-quarter gross domestic product and the strong January durable goods report.

Treasuries slipped on the report, as bond investors began to think the Fed will be raising rates sooner than expected. The yield on the two-year Treasury jumped to 3.50% from 3.42%, putting it 175 basis points above the fed funds target rate. That's the largest spread between the two-year and the funds rate in seven years. Stocks maintained a solid advance Friday as the good news rolled in.

Meanwhile, the fed funds futures market, which trades on expectations for the fed funds rate, is pricing in a 72% chance the Federal Open Market Committee will tighten by a quarter point at its May 7 meeting. The futures have fully priced in a quarter-point hike after the meeting June 26 and 27, and is putting the odds the funds rate will be a half point higher by then at 70%.

Agreeing to Disagree

Still, most economists regard market expectations the Fed will raise rates so quickly as nonsense. Greenpan & Co. have cut rates 11 times in a row, dating back to January 2001, amid mounting signs of economic weakness.

"Let's allow ourselves a few months to celebrate the end of recession before we worry about the onset of Greenspan the Grinch," says Robert Barbera, chief economist at Hoenig & Co.

Although the news on the economy has been good, Barbera doesn't think it's been so terrific that the Fed is on the verge of putting on the brakes. The employment report, for example, may show the erosion in jobs is coming to an end, but it doesn't foretell the kind of tightness in labor that leads one to worry over inflation.

As for the market's interpretation of the economy, says Barbera, "if market prices were always correct, there would be no reason to trade."

Even economists who are quite upbeat on the recovery's prognosis share Hoenig's view. Morgan Stanley chief U.S. economist Richard Berner this week raised his forecast for GDP growth this year to 2.6% from 1.4%.

"May is ahead of my timetable," he says. "I think the Fed is going to want to see not just signs of stronger growth, but signs of stronger growth for a while." Berner, who has what economists like to call street cred for being early to forecast both the recession and the recovery, thinks the Fed will start hiking in August.

Market Trumps Economists

But Bianco Research head Jim Bianco says investors would be better off paying attention to the market then the economists. "It's the market that drives Fed policy," he says. "If the market prices in a tightening for May and it stays, the Fed will tighten." And, he adds, unless the data suddenly turn unkind, the market's current forecast seems like it's going to stick.

Bianco's idea that the market, rather than the economic data, drives Fed policy is controversial, but one can give it at least some credence. If nothing else, a market tightening forecast tells the Fed that it's all right to raise rates -- that it's not like everyone will start raising a big stink and wondering what's in Greenspan's Kool-Aid.

It's also worth remembering the rate debate in the beginning of the year. In early January, 19 of 24 economists in the Bloomberg poll expected the Fed to lower rates by another quarter point to 1.5% at the Jan. 29 and 30. The fed funds futures market said the Fed would stay on hold.

Guess which one was right?