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Benchmark T-Note May Hit 5%

If data point to a 5% funds rate, Treasury yields are likely to follow.

The January employment report virtually locks in the likelihood of another interest rate increase when the

Federal Reserve

meets again on March 28. Moreover, the report increases the odds that Fed Chairman Ben Bernanke will deliver hawkish testimony when he appears before the House Financial Services Committee on Feb. 15 to deliver his first semiannual monetary policy report to Congress. The fed funds rate now appears likely to reach 5.0% following the May 10 FOMC meeting.

The details of the January payroll report fit with many of the lines of progression that history says we should expect with respect to the economy and the outlook on inflation. In particular, with the jobless rate falling and corporate profits high, wages should be expected to rise, boosting inflation pressures. Such is in fact occurring, with average hourly earnings rising 0.4% for a second straight month, the first such streak since the middle of 2000. The wage gain puts the year-over-year figure at 3.3%, a notch above the 15-year average, and it's probably headed higher.

The increase in hourly earnings is not the only form of income that is rising; personal income has been rising solidly on the whole. In other words, beyond wages, there has recently been very strong growth in other forms of compensation, including bonuses, for example. In addition, there has been strong growth in dividend income, interest income and proprietorship income, helping consumers withstand high energy costs.

Bernanke's 2003 Take on Sub-5% Unemployment

The payroll gain of 193,000 must be put in the context of the upward revision of 81,000 seen in the previous two months. The gain is much more than the 150,000 per month that is considered necessary to keep the jobless rate steady, given the amount of new entrants into the labor force. That is why, in fact, the jobless rate is now falling, dipping to 4.7% in January compared with 4.9% the previous month, to its lowest level since July 2001. The decline is very important when put in the context of the Federal Reserve's past two policy statements:

Possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.

It is widely believed that 5.0% probably represents full employment. Those who disagree, in most cases, put the rate closer to 4.5%. Whatever the case, the current 4.7% rate appears to be below where Bernanke perceived full employment to be. Here are his remarks from a June 2003 speech:

From 1994 to 2002, core PCE inflation remained in a stable range while the unemployment rate averaged about 5 percent; so let us suppose ... that the unemployment rate at which inflation is stable is 5 percent.

With that in mind, it therefore appears likely that Bernanke's Feb. 15 testimony will lean to the hawkish side and hint at the likelihood of additional interest rate hikes.

Main Street Will Gain Confidence From Headlines

For Main Street -- which, judging from recent consumer confidence data, already appears to have been buoyed by the job market (and perhaps the warmer-than-normal winter temperatures, which have taken away some of the sting of high energy costs) -- the drop in the jobless rate will play very well. The jobless rate is one of the few data points that the general public has a strong understanding of, so the drop almost certainly will help boost confidence further, all else equal.

As I have noted for months, Treasury yields rarely trade below the federal funds rate; they do so only when an interest rate cut is on the horizon. With the funds rate likely to go to at least 4.75% and probably toward 5.0%, Treasury yields should follow. That said, the recent jump in Treasury yields has created conditions that could be considered oversold. Moreover, there has been heavy put-buying of late in the futures market for 10-year T-notes, so the march toward 4.75% may not occur right away -- but it is likely to occur by the March 28 FOMC meeting.

I've said also that any disappointment regarding the Fed outlook probably would occur early in the year, when those who were expecting a halt to the Fed's hikes adjusted to the reality of additional hikes. In the end, however, the funds rate will probably end the year somewhere close to current expectations, making the prospect of more rate hikes more of a short-term dilemma. This is a lot different from a year ago, when what separated my camp from those who expected a halt to hikes was as much as two percentage points or more (the funds rate began 2005 at 2.25%).

Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of

The Strategic Bond Investor

. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback;

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