Jobs Report Says Rate Hike, and Bonds Say OK

The much-stronger-than-expected report makes a rate hike on Aug. 24 almost a certainty.
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Anyone out there who still thinks the

Fed

won't hike rates Aug. 24? Didn't think so.

Today's whopper of an

employment report

put to rest the notion that the Fed might hold off at its next rate-setting committee meeting, and caused a broadbased selloff in the Treasury market. Total nonfarm payrolls grew by 310,000 in July -- the

Reuters'

consensus was for a 199,400 increase.

"It's pretty simple -- the number was a shock, and the markets reacted accordingly," said Mike McGlone, vice president at

Aubrey G. Lanston

.

But though a quarterly refunding and several more important economic releases loom next week, traders said the levels reached today are consistent with the expectation of another rate hike, and so they're not expecting yields to rise much higher than current levels.

Lately the 30-year Treasury bond was down 1 22/32 to trade at 87 15/32, as the yield rose by 14 basis points to 6.18%.

Most of these losses immediately followed the 8:30 a.m. EDT release of the employment report. The market was looking for yet another strong report -- but this report was stronger than strong. In addition to the job growth, average hourly earnings exceeded the markets expectation, rising 0.5%, compared with the 0.3% forecast. On a year-over-year basis, average hourly earnings are increasing at a 3.8% rate. This is faster than May's 3.5% rate, but still below July 1998's peak of 4.3%. June's payroll increase was revised upward to 273,000 from an original 268,000.

Until now, most of the Fed's worry that tight labor markets would result in wage pressures had not been confirmed by government data. This week the Fed got several clues that wage inflation is creeping into the economy. Along with today's report, yesterday's figures on

productivity

showed that unit labor costs rose 3.8% in the second quarter, the highest rate of increase since the fourth quarter of 1997. Productivity only rose 1.3%, compared with 3.6% the previous quarter.

"The wage pressures seem to be percolating again," said Josh Feinman, chief economist at

Deutsche Asset Management

, who believes the Fed is going to hike rates at the end of the month. "Nothing in this market is flashing red. There's no emergency, but every little thing is flashing yellow."

For the last year and a half, the strength in the job market was confined to the service economy and construction jobs, with manufacturing left behind. But manufacturing displayed its first increase in jobs in the last 17 months, notwithstanding one month when striking

General Motors

(GM) - Get Report

workers returned to work. The sector added 31,000 jobs, and the average manufacturing workweek rose to 41.9 hours a week, vs. 41.7 hours per week in June. The overall average workweek held steady at 34.5 hours per week.

Now, Fed Chairman

Alan Greenspan

has "all the fuel in the world he wants to raise rates," said McGlone. "He warned us that if the data comes out stronger than expected, he would raise rates, and when he warns you like that he usually does."

But the market's readiness for a rate hike is the chief reason bond yields might not rise in the weeks leading to the Fed meeting. Next week's most important economic release is the July

Producer Price Index

, released Friday, which may show a large increase due to a steady rise in energy prices (and a rise in several different food products). Expectations are for a 0.3% rise in the PPI. Feinman believes that if price increases are seen in the crude and intermediate stages of processing goods, producers could pass on those price increases to consumers down the road, resulting in price inflation.

But as far as August's Fed meeting is concerned, this report's really like finding a 14th witness to a crime that 13 others have already videotaped -- what can it add?

"These are levels I'm comfortable with," said Scott Graham,

Prudential Securities'

head of government trading. "We're all anticipating stumbling through these numbers and ultimately these will turn to be decent buys."

The

Treasury

begins its quarterly refunding Tuesday with the sale of $15 billion of five-year notes, and continues with Wednesday's 10-year note auction and concludes with Thursday's sale of 30-year bonds. Generally the market undergoes a bit of selling before the refunding as investors make room for the newest securities, but Graham doesn't expect the market will have problems absorbing the supply, because the Treasury is paying down debt this quarter. "There's going to be a lot of cash in the marketplace," he said.

The fed funds target rate was most recently raised to 5% from 4.75% at the Fed's last meeting, June 30.