The credit crunch is coming home to roost in 2008, and Friday's employment report could solidify recession fears in the markets.

"Employment growth is expected to moderate significantly, associated with flatter economic activity," writes Bank of America chief economist Mickey Levy. His warning comes as Wall Street braces for what many fear will be massive rounds of layoffs of traders, salespeople and others tied to the mortgage-backed-securities businesses in investment firms that have logged severe losses in 2007.

Rumors are swirling through the new year about job losses at Merrill Lynch ( MER), Bear Stearns ( BSC) and Citigroup ( C), in particular, as these firms marked some of the biggest declines and losses.

Cramer: Make Jobs Data Work for You

The nonfarm payrolls report for December comes on the heels of a surprisingly benign slew of economic data released through most of 2007. While economists waited for signs of an economic decline, the seizing up of liquidity in August seemed to have no severe impact on the real economy. The markets barely noticed data points like the Institute for Supply Manufacturing surveys or factory orders, as traders trained their eyes on the more immediate machinations of a credit crunch.

Canceled private-equity deals, writedowns on mortgage-backed securities and mortgages by Wall Street's banks and lenders like Countrywide ( CFC), the dried-up short-term commercial paper market, and how much higher the London interbank offered rate was running compared with the fed funds target rate reigned as key market drivers.

Indeed, the data fueled bulls' hopes that the economy was resilient enough to weather the housing recession and liquidity crunch without dramatic spillover to other parts of the economy. Holiday shopping was not terrible and employment remained positive, if slightly weaker, and business spending hadn't gone negative. Housing retained center stage as the main drag, and even there, lower Treasury bond yields were enabling a wave of refinancing that was billed as a hopeful sign about the housing market's future.

But the bears are getting their just rewards now that the new year's begun.

Bank executives' decisions last fall to tighten their lending standards and U.S. corporate executives' decisions to whittle down budgets, postpone capital spending and gird against an economic downturn are finally showing up in the data for December.

Wednesday's ISM survey revealed a slump in manufacturing that suggests the economy may experience a glut of inventory as business spending weakens. The surge to $100 per barrel for the price of oil complicated matters as well, as the Fed attempts to contain inflation while growth slows.

"You have an enormous amount of uncertainty here, and firms are playing it close to the vest -- no unnecessary capital spending and no unnecessary hiring." says Joe Brusuelas, chief economist at IDEAglobal. "We are going to have a weak fourth quarter, in part a response to the financial shocks of August through November."

Friday's employment report may just pile onto the week's gloomy pile of reports if it comes in near to analyst expectations. If it is significantly weaker, it will compound stock market jitters about recession and likely pressure U.S. Treasury yields even lower.

"The jobs number may be the most important in years, and since the general tone in the market has been negative, most traders are erring on the side of caution," says Randy Diamond, trader at Miller Tabak, referring to the stock market's flat performance Thursday.

Analysts believe the government will report firms added 70,000 jobs in December, which would be down from November's 94,000 new jobs added and October's surprisingly strong 170,000 jobs.

The ADP National Employment report, which measures private company employment, came out Thursday to show just 40,000 new jobs added in December. Add 20,000 or so new jobs that usually can be expected in the government sector and it amounts to nearly the consensus estimate.

Bank of America's Levy believes unemployment will rise through the first half of 2008 to about 5.2%, from its current 4.8% level.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click here to send her an email.

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