Updated from 10:38 a.m. EST

Treasuries ended Friday's session down, but off their lows, after the February payrolls report came in a touch stronger than estimates, reinforcing expectations for two more fed funds rate hikes by midyear.

The market has priced in 100% odds that Federal Reserve policy makers will raise the overnight lending rate by 25 basis points to 4.75% on March 28, and 95% odds that the rate will hit 5% in May. The fed funds futures contract shows 24% odds of a 5.25% funds rate by the June FOMC meeting, up from 10% yesterday and zero percent a week ago, according to Miller Tabak.

Recent strong readings on employment and capacity utilization have pushed Lehman Brothers economists to raise their fed funds rate target to 5.5% by August or September. The data have also weighed on the 10-year note, driving the yield to its highest levels since June 2004. The level of the 10-year yield is used to determine mortgage rates and corporate bond yields.

The benchmark 10-year note ended the day down 8/32 of a point to yield 4.76%, after running up to 4.78%, while the 30-year bond slid 14/32 to yield 4.75%. Bond prices and yields move in opposite directions.

On the short end of the curve, the two-year edged lower 2/32 to yield 4.73%, and the five-year lost 4/32 to yield 4.77%.

The payrolls report was a mixed bag for inflation watchers and ultimately "not a market moving event," wrote David Ader, U.S. government bond strategist at RBS Greenwich Capital. "With today's key data out of the way, we can focus on... anticipation for next week's wall of data."

Next week the market will get hit by the CPI, the breakdown of foreign Treasury holdings, retail sales, sentiment numbers and housing starts information. The Fed will also release its Beige Book survey of regional economic health.

Housing figures will be closely watched for signs of a cooldown that ABN Amro economist Steven Ricchiuto says could be a drag on real economic growth.

Mortgage giant Freddie Mac said in its weekly report that rates on the 30-year, fixed-rate mortgages averaged 6.37%, up sharply from 6.24% the previous week and the highest level since they averaged 6.44% in the week of Sept. 5, 2003

"Stronger than expected gains in the manufacturing and service industries -- coupled with higher labor costs -- ignited inflation concerns, which led to the rise in mortgage rates this week," Frank E. Nothaft, chief economist at Freddie Mac, said in a statement.

In employment news, a stronger-than-expected 243,000 jobs were created in February, vs. expectations for 210,000 jobs in the month. The headline figure could ramp up inflation fears at the Fed, says Hugh Johnson, chairman of Johnson Illington Advisors. Central bankers have said they are eyeing employment data for signs that the nation has hit "full employment," the greatest employment level the nation can handle before wage inflation sets in.

But the payrolls number for January was downwardly revised to 170,000 from an initial reading at 193,000. More importantly, the unemployment rate ticked higher to 4.8%, vs. expectations that it would hold steady at 4.7%.

Prior to the report , Rick Klingman, chief Treasuries trader at ABN Amro, said that 10-year yields would likely hold between 4.80% and 4.70%, and the employment data gave him little impetus to change that call.

"Ultimately, the payroll report was kind of a nonevent for the market, in that you saw some information that was strong and some that was favorable for bonds," he says. "We just have to wait for more information ... for some inflationary numbers."

Average hourly earnings rose the expected 0.3%, while the average workweek came in at 33.7 hours, just shy of the expected 33.8.

"The average work week continued to sit at the low end of the range, and this is the most important leading indicator for a tightening job market," says Michael Cheah, a portfolio manager with AIG Sun America Asset Management. "Companies will not employ new workers until the employees they have are being worked more hours. Another way to look at it would be to say that there is not enough work to keep people fully utilized during office hours."

Cheah also says that the market is putting too much emphasis the 0.3% wage gain, which "in the scheme of things is really not that much ... it's a cup of coffee."

In other economic news, January wholesale inventories rose by 0.1%, less than the expected 0.5% rise; the previous month's inventories gain was downwardly revised to 0.9% from 1.0%.

Sales rose by 1.0%, bring the inventory-to-sales ratio to the record low 1.14 last seen in October.

And the government logged a record sized $119 billion deficit in February -- $5 billion more than a year ago. Receipts rose by 12% and outlay spending rose by 8%.

The record February deficit leaves the year-to-date deficit $6 billion smaller year-on-year.

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