• Reuters


A blowout jobs report has changed the calculus for investors for what the Federal Reserve might do in coming months, resetting expectations for how markets might behave if the U.S. economy continues to strengthen even as global growth lags.

Strong job market growth, along with solid wage gains, has put talk of deflation and collapsing oil prices on the back burner and shifted focus to the Fed’s plans to raise rates, perhaps as early as June.

“The market has not priced in an early Fed,” said Richard Gilhooly, an interest rate strategist at TD Securities in New York.

Nonfarm payrolls beat forecasts with an increase of 257,000 last month, government data showed on Friday, while revisions brought the three-month gain above a million jobs for the first time since 1997.

“With this kind of a number, the Fed can go in the first half of the year. One more report like this and the Fed will be going earlier,” said Gilhooly.

The effect was most noticeable Friday in intermediate-dated bonds like five-year notes, which sold off on expectations of a more aggressive-than-expected Fed. Interest-rate sensitive sectors in the stock market, including REITs and utilities, could also be hit.

Despite recent indications Fed policymakers were still looking to raise rates by the summer, markets had been volatile as softer data points, including December consumer spending and factory orders numbers, made traders shift their expectations to late 2015 or early 2016.

The reaction to Friday’s data across markets, however, suggests a more clear view of interest rates rising.

Futures contracts tied to the Fed’s main policy rate now show traders see a 63 percent chance that the first Fed rate hike will come in September 2015, and a 46 percent probability of a July rate hike. Before the jobs report, traders were betting the Fed would wait until October to raise rates.

Credit Suisse analysts said shortly after the payrolls data that they expect intermediate-dated debt like five-year Treasury note yields to increase on expected rate hikes.

However, they believe longer-dated bonds will continue to be supported by a shortage of supply and a desire for yield from overseas investors. At a yield of 1.92 percent, the U.S. 10-year Treasury note boasts a higher yield than the debt of most developed economies, even struggling nations like Spain and Italy.

With that scenario in mind, Credit Suisse recommends trades that will benefit from the Treasury yield curve flattening.

The desire for yield may keep the U.S. dollar rally intact; the dollar index rose more than 1 percent Friday, moving closer to a 15-year high hit two weeks ago.

The jobs report also roiled eurodollar futures, a key market where hedge funds and other investors make bets on the direction of short-term rates. Coming into the jobs report, data from the U.S. Commodity Futures Trading Commission showed leveraged traders held a long position in three-month eurodollars of more than 1.03 million contracts, the longest such position since May 2013, according to the CFTC.

Those contracts, particularly those maturing in September and December, sold off sharply on Friday, with December contract volume exceeding 923,000 as more traders now see rates rising.

Historically, the beginning of a Fed tightening cycle is positive for stocks as it coincides with a stronger economy. But the gains will likely not come before equities see some pain.

If the current jobs scenario remains in place, stocks could sell off in the second quarter in a “panicky correction” as the Fed begins to focus its debate on a rate hike and the language in its statement shifts, said Brian Reynolds, chief market strategist at Rosenblatt Securities in New York.

“In the next few months you will see more volatility as the Fed changes language,” he said.

On Friday, the broader stock market was little changed, but stocks in the S&P utilities sector, preferred by low-risk investors during the current low-return period in bonds, slid as prospects for higher rates weighed. Utilities were the best performer among S&P sectors in 2014, gaining nearly 30 percent on a total return basis as yields dove.

The sector was down 3 percent in afternoon trading, on track to post its largest daily drop since August 2011.

Jim Paulsen, chief investment officer at Wells Capital Management in Minneapolis, said as rates begin to rise, stocks in the energy and materials sectors could outperform.

He also saw a rate rise as negative for residential real estate investment trusts, though for REITs tied to commercial space it could be more of a positive.

Financials, seen outperforming as rates rise, were among the strongest sectors on Friday.

“By maintaining zero interest rates the Fed sentenced financials to no income on their balance sheets, now they’re going to introduce some income flow,” said Paulsen.

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