Job slump edges market expectations to rate cut

NEW YORK (Reuters) - With the U.S. job market shrinking at a worrying pace, investors are increasingly setting aside their inflation fears and predicting the Federal Reserve's next rate move may be down.

Government bonds are one of the few markets to gain in the somber environment of consumers cornered by falling house prices and tight credit, slumping corporate profits and the specter of inflation receding as commodity prices tumble.

"The message from the fed funds market and the Treasury market as a whole is that there is still a lot of bad news to come in the economy because of the credit crunch," said Jay Mueller, senior portfolio manager with Wells Capital Management in Milwaukee, Wisconsin.

The benchmark 10-year U.S. Treasury note's yield, which moves inversely to its price, dipped below 3.55 percent to the lowest since mid-April on Friday after a report showed the jobless rate jumped above 6 percent. Accumulating evidence of a faltering economy boosts government bond prices.

The jobs report also showed non-farm payrolls fell for the eighth straight month, shifting U.S. short-term interest rate futures to show that market participants now reckon rate hikes are off the table and there is even a slight 10 percent chance of a rate cut by year end.

"The August employment report reinforces the idea I have shepherded recently that the U.S. economy is about to enter a dark period, with economic activity slipping substantially from the second quarter's 3.3 percent pace and perhaps set to contract in the fourth quarter," wrote Tony Crescenzi, chief bond market strategist with Miller, Tabak & Co. in New York in an email note on Friday.

"This idea is one that is already partly priced into the financial markets," wrote Crescenzi, "although it could take more time to fully price in."

"Today is the first test," Crescenzi added. "The jobless rate moved above the Fed's forecast and rate cut odds have materialized."

Shorter maturity Treasuries, which respond closely to expectations for official interest rate moves, are telegraphing that the U.S. central bank will hold the federal funds target rate at 2 percent for next several months, and might cut.

The 2-year note's yield slipped to 2.08 percent intraday on Friday, the lowest since mid-April and just 8 basis points above the Fed's short-term lending rate target.

Even before Friday's jobs report, some Fed officials were hinting that should crude oil prices continue falling and inflation pressures recede, that an interest rate cut is not out of the question.

San Francisco Federal Reserve Bank President Janet Yellen said on Thursday that another cut to benchmark interest rates was unlikely, but cannot be completely ruled out. The Fed could be forced to lower rates if the "adverse feedback loop" between rising unemployment, weak consumer spending, falling home prices and tight credit conditions were to worsen substantially, Yellen said.

For the Fed to cut its key fed funds target rate below 2 percent, the central bank would have to be confident the threat from inflation, which has accelerated to the fastest clip in some two decades, had dissipated.

Fixed income analysts reckon that after crude oil's precipitous drop in recent weeks to below $106 per barrel on Friday, from a record high above $147 in July, monthly readings of U.S. consumer and producer price indexes could soon turn negative.

That prospect is boosting longer maturity bond prices, which are especially sensitive to inflation, while shorter maturities are benefiting from investors' sense that rate hikes are unlikely, for now.

"The big drop in oil prices has meant the Fed doesn't have to worry about taking overt steps to combat inflation," said Mueller.

On Friday, the Economic Cycle Research Institute's U.S. Future Inflation Gauge showed inflation pressures fell to a six-year low in August, braked by falling commodity prices and labor market conditions.

However, economists question how effective Fed rate cuts would be since the U.S. economy is hamstrung by a year-old credit crunch.

To get lending flowing smoothly again to consumers and companies, the central bank's existing facilities to provide cheap funding will be more useful than rate cuts, analysts say.

"The Fed has front loaded a lot of the rate cuts. It would take extreme worsening in the economy for another cut. But I'm not sure another 25 basis-point cut is going to get to the root of the problems," said Brian Edmonds, head of rates trading at Cantor Fitzgerald in New York.

(Additional reporting by Richard Leong, Ros Krasny and Rodrigo Campos; Editing by Neil Stempleman)