Bond Traders Get Inflation Itch

Even a weak jobs report can't keep yields down for long as wage pressures rise, as do the odds for more Fed tightening.
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After refusing to believe that inflation was under way earlier this year, the bond market is now determined in its belief that interest rates will keep on rising no matter what -- even amid evidence that the labor market is cooling.

Following Friday's weaker-than-expected jobs report for October, Treasury bond prices first rose, and their yields fell. But the price gains quickly faded. In recent action, the benchmark 10-year Treasury bond was unchanged while its yield stood at 4.65%.

The 10-year yield has been rising for two months, ever since Hurricane Katrina's hit to the Gulf Coast created a spike in energy prices. After some discussion that the

Federal Reserve

might stop raising rates in reaction to the hurricane's impact on growth, the benchmark yield is above its previous 2005 high of 4.62%, hit on March 28.

However, there's now evidence that energy prices themselves are not only contributing to inflation fears but, potentially, also reducing employment. Meanwhile, the inflation picture is not improving one bit.

The October jobs report was truly disappointing on the hiring front -- only 56,000 jobs were added in October and much of the weakness was outside of the Gulf Coast areas that were affected by the hurricanes. Wall Street economists were expecting 120,000 new jobs. September's job loss was revised to 8,000 from 35,000 while August's gain was revised downward from 211,000 to 148,000.

According to Kathleen Utgoff, the commissioner of the Bureau of Labor Statistics, "it is possible, of course, that employment growth for the nation could have been held down by indirect effects of hurricanes Katrina and Rita, for example, because of their impact on gas prices.''

Facing higher energy costs themselves and assuming that consumers may spend less, it seems that firms are now hiring less.

However, average hourly gains jumped to 0.5%, the highest rate in over two years. Sectors showing notable strength included construction and transportation. But this was likely the result of reconstruction efforts around the Gulf Coast and the end of a strike at

Boeing

(BA) - Get Report

.

"If firms have to face not only high energy and commodity prices but also increasing labor costs, then the inflationary pressures could be even greater than we think," writes Joel Naroff, president of Naroff Economic Advisors. "And that could push the Fed to go past neutral and start tapping on the brakes."

This also seems to be the opinion in the market.

According to Miller Tabak, the fed fund futures market sees a 100% chance of another quarter-point hike on Dec. 13, and a 92% chance of another hike at the Jan. 31 meeting, which will be the last presided over by Fed Chairman Greenspan. The market is now also pricing a 62% chance that the Fed hikes again on March 28, which would presumably be the first for Fed Chair appointee Ben Bernanke, taking the fed funds rate to 4.75%. The March 28 odds stood at 50% on Thursday.

A determined Fed, as was evident in

Greenspan's speech on Thursday, has finally really convinced a previously reluctant bond market that it means business, according to Sid Mokhtari, interest rate strategist at CIBC World Markets.

"The bond market had not really bought into the notion of inflation, even as energy prices rose, because core inflation remained benign," he says. "But now that headline inflation has reached such elevated levels, the psychology has changed."

Now, bond market players are sticking with Greenspan's and the Fed's predictions that the pinch of high energy costs will be short-lived -- meaning the economy isn't going south any time soon. Moreover, lower gasoline and natural gas prices so far (amid a warmer-than-usual fall season in the U.S.) are abating fears of a consumption meltdown this winter.

In addition, central banks globally now say they have inflation on their radar screens. The outlook for higher bond yields in Europe and Japan, for instance, pressures the U.S. bond market toward higher yields if it wants to continue attracting capital. The European Central Bank left rates unchanged Thursday but President Jean-Claude Trichet said: "We can move at any time, and we have warned the market very clearly of this. Strong vigilance is of the essence in our eyes, and we clearly see increased risks to price stability."

CIBC predicts that the yield of the 10-year yield will rise to 4.90% to 5% by early next year. But that's based on expectations that the Fed stops raising rates when the fed funds rate stands at 4.50%; the market is now expecting more.

A lot might depend on how much rising yields affect demand for homes, amid some evidence of a cooling market. Before he leaves, Greenspan seems to wants to engineer a soft-landing for the U.S. economy. It would seem that this does entail making sure that the asset bubble his policies helped create deflates slowly.

Stocks, meanwhile, were also pressured after the jobs report. In recent action, the

Dow Jones Industrial Average

was down 13.83 points, or 0.13%, at 10,508.76. The

S&P 500

index was down 1.85 points, or 0.15%, at 1218.09.

Lower crude oil prices pressured energy shares, with the

Amex Oil Index

recently losing 2.4%.

Valero

(VLO) - Get Report

,

Marathon Oil

(MRO) - Get Report

and

ConocoPhillips

(COP) - Get Report

were leading the downside.

The

Nasdaq Composite

, however, remained above water, recently gaining 3.06 points, or 0.14%, to 2163.28. Shares of

Expedia

(EXPE) - Get Report

surged 9% after posting earnings that beat estimates.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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