A huge rally is underway in the Treasury market in reaction to the February

employment report

, and the big drop in bond and note yields reflects a major shift in the prevailing outlook for monetary policy.

Before the release of the jobs report, traders saw significant risk that the

Fed

would hike interest rates at its next meeting, March 30. Now, they are as sure as they can be that the Fed will leave rates unchanged.

"The Fed's out of the picture right now,"

Lehman Brothers

economist Joseph Abate said. "It has been priced out, or is rapidly being priced out."

The benchmark 30-year Treasury bond lately was up a majestic 1 27/32 at 95 12/32, off its best levels of the day (it was up as much as 2 7/32 around 9:30 a.m. EST), plunging its yield 13 basis points from 5.70% to 5.57%. Shorter-maturity note yields are lower by somewhat smaller amounts. The two-year Treasury note was up 6/32, dropping its yield from 5.18% to 5.10%.

Ironically, the

nonfarm payrolls

component of the employment report was stronger than the average forecast.

Nonfarm payrolls swelled by 275,000, vs. expectations for a gain of 245,000 among economists surveyed by

Reuters

.

Bonds are rallying anyway because few traders believed the average forecast. Instead, they conjured up visions of as many as half a million new jobs and speculated that the long bond's yield might go to 6% in response. And market watchers say a significant number of them sold the bond short in hopes of profiting from such a move.

So when the number broke, it was so much friendlier than the nightmares had been that traders bought bonds in relief -- or to cover their suddenly underwater short positions. "This is being driven by the fact that the report was not as strong as most people had feared," Abate said. The 275,000 increase "is still a pretty sizable gain, but it's not as big as the 400-plus numbers people were bandying about."

"I think it's all short-covering,"

Warburg Dillon Read

Treasury market strategist Mark Mahoney said, adding: "We don't have to worry about the Fed tightening with that number."

At the same time, the other major components of the jobs report -- the ones that detect wage pressure -- were genuinely friendly. The economy may be strong, they suggest, but there is still little danger of inflation heating up.

Average hourly earnings

ticked up just 0.1%, versus expectations for a 0.3% gain. That caused the annual growth rate of average hourly earnings to drop to its lowest level since July 1997, 3.6%. And the unemployment rate expanded slightly to 4.4% from 4.3%.

The tone of the report also allowed traders to take heart from an article in the latest issue of

Business Week

, on newsstands this morning. Headlined "Serene at the Fed," the article asserts that Fed Chairman

Alan Greenspan

"privately sees little justification for a rate boost, according to sources familiar with his thinking. For one thing, despite heartening evidence that parts of Asia are slowly recovering from a deep recession, the Fed chairman is still fearful that a new financial shock could send the global economy back to its sickbed," the article says.