A report showing the manufacturing sector weathered the impact of hurricanes Katrina and Rita in September surprisingly well could have been reason to cheer. But if there was any cheering, it was from those betting against stocks and bonds.

The Institute for Supply Management's manufacturing survey fueled mounting concerns about inflation, and supported the case that the Federal Reserve will again hike rates at its next meeting in November.

The ISM said its manufacturing index jumped to 59.4 in September from 53.6 in August. That was well above expectations for the index to dip to 52.0. But markets focused on a key gauge of inflationary pressures inside the ISM report: The survey's prices paid index skyrocketed to 78 from 62.5.

"While energy prices and the impact from Hurricane Katrina are major concerns, the manufacturing sector has regained significant momentum," said Norbert Ore, chairman of the ISM business survey committee.

Firms indicated they had boosted orders and production on expectations that materials may become scarce because of Katrina-related disruptions. They also expect business activity to pick up as part of the post-hurricane reconstruction.

The economic resilience could have been enough to convince the Fed to continue lifting rates by itself; in conjunction with the prices paid index, it almost certainly will.

In part in reaction to the ISM data, the Dow Jones Industrial Average was recently down 0.3%, at 10,537. The S&P 500 was down 0.2% at 1226.51. Merger news and a dip in crude -- oil was recently down 48 cents at $65.75 on Nymex -- helped prevent wider losses.

The Nasdaq Composite was recently up 0.2%, at 2156.13. Besides lower oil, the tech-heavy index remained supported by news that Symantec ( SYMC) said it will acquire information technology company BindView ( BVEW) for $209 million. Also, Google ( GOOG) was higher on word that it plans a collaboration with Sun Microsystems ( SUNW), which was recently up 7% in heavy volume on the news.

The benchmark 10-year Treasury bond fell 13/32 in price, while its yield, which moves inversely and reflects market expectations of inflation, rose to 4.38%. The price of gold, however, was recently down $3.70 at $470.60 an ounce as the dollar rose on expectations of more Fed rate hikes.

The ISM report "gives a green light for the Fed to continue to tighten on Nov. 1 and that any Fed pause will tend to happen later rather than sooner," says Michael Gregory, interest-rate strategist at BMO Nesbitt Burns.

Because of the relatively low manufacturing activity in the Gulf Coast, the region hit by Katrina, the ISM survey gives a "cleaner picture on underlying economic activity" than other reports, such as Friday's employment report, he says.

Despite a big increase in energy prices over the past year, headline inflation measures have remained relatively contained, convincing many that the Fed would perceive risks of an economic slowdown, or even a recession, as outweighing inflation risks.

"But the latest hurricane-related energy spike has served as somewhat of a trigger which rattled people's expectations of inflation, and we're seeing this in firms feeling more comfortable in adding energy surcharges," Gregory says.

All that is confirming the clear signals from Fed officials last week that the central bank was firmly keeping inflation within its cross-hairs.

There are other key reasons for higher inflation expectations, such as the huge government spending (which could be as high as $200 billion) expected to rebuild post-hurricane devastation in southeastern states. Building materials will be in high demand, the larger federal deficit will pressure the dollar and upward pressure on rates can be expected from more supply of government debt.

According to Gregory, the yield of the benchmark 10-year note is now poised to break above 4.40%, a level last touched on Aug. 10, which would "put it on a fast track to 4.60%," its March high. The yield can then be expected to incrementally rise to 4.70% to 4.75%, he says, levels it hasn't reached since the Fed began raising rates in June 2004.
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; click here to send him an email.