Dollar gains, bonds fall on U.S. rate-hike fears

By Herbert Lash

NEW YORK (Reuters) - The U.S. dollar extended gains and U.S. government debt prices fell on Monday on fears the Federal Reserve will hike interest rates sooner than expected after last week's surprisingly strong jobs data.

The selling of bonds followed a steep sell-off on Friday after the U.S. Labor Department said employers cut far fewer jobs in May than had been forecast, sparking speculation that a recession might end this year and later spur higher rates.

Eurodollar futures on Monday priced in a rise in U.S. interest rates of almost 1 percentage point within a year after Friday's payrolls report.

Oil fell to almost $68 a barrel on the stronger dollar and weakness in U.S. and European stocks.

U.S. stocks rebounded before the close, disregarding lowered iPhone prices from Apple (AAPL.O) and disappointing sales from McDonald's (MCD.N).

Longer-dated euro-zone government bonds closed higher while their U.S. counterparts initially rose as the weakness in stocks boosted the allure of lower-risk fixed-income assets, driving the benchmark bund yield off a seven-month peak.

Longer-dated U.S. Treasuries later turned lower as the improving economic outlook sparked fears that the Fed will be forced to drop its near-zero interest-rate policy.

"The focus now is on the Fed actually tightening rates, sort of, into the fall," said Thomas di Galoma, head of fixed- income rates trading at Guggenheim Capital Markets LLC in New York.

"Reality on the Fed is just changing. There was a feeling that the Fed would be able to leave rates at pretty much zero through 2009 and probably well into 2010," he said.

The rate-sensitive two-year note fell 9/32 in price to yield almost 1.44 percent, the highest since early November and up from 0.96 percent late on Thursday.

Benchmark 10-year notes fell 17/32, pushing yields up to 3.91 percent from 3.84 percent at Friday's close.

Gold futures ended below $950 an ounce as the dollar rose sharply on signs of an economic recovery, reducing the appeal of bullion as a hedge against a weakening U.S. currency.

The August gold contract tumbled 1.1 percent, or $10.10, to settle at $952.50 an ounce in New York.

The euro fell broadly after ratings agency Standard & Poor's cut Ireland's sovereign credit rating to AA, the country's second downgrade by an agency in three months.

The downgrade provided a fresh catalyst to sell the euro, which fell to a nearly two-week low of $1.3806 and bolstered the dollar.