Jobs report jolts Wall Street bulls as inflation fears return

By Davide Barbuscia

NEW YORK (Reuters) - Much stronger-than-expected U.S. job growth stopped early-year rallies in stocks and bonds dead in their tracks on Friday, forcing Wall Street to recalibrate expectations for how much more hawkish the Federal Reserve will need to be in its fight against inflation.

An unexpectedly dovish message from Fed Chair Jerome Powell earlier this week had emboldened investors looking for evidence of the so-called "soft landing" scenario that has fueled a market rally this year, in which the central bank can tame inflation without causing a recession.

But Friday's data, which showed U.S. employment growth accelerating sharply in January, renewed the inflation concerns that hammered stocks and bonds last year, reinforcing some investors' belief that the twin gains in both asset classes may have gotten ahead of themselves.

The S&P 500 index was down about 1% on Friday though still up 8% on the year. Yields on the benchmark 10-year Treasury, which move inversely to prices, gained 12 basis points despite having declined by 30 basis points this year.

"This report gives us more confidence that the Fed's got to keep going, and that increases at the margin the odds that we do have to deal with a recession at some point later this year," said Michael Reynolds, vice president of investment strategy at Glenmede, who has been underweight equities while holding a larger allocation to fixed income and cash.

Job growth and wages are a chief concern for the Fed in its attempt to lower inflation to its 2% target rate after it surged to 40-year highs last year. The Labor Department's nonfarm payrolls report on Friday showed a gain of 517,000 jobs in January, almost three times what was expected.

The reading quelled hopes that the U.S. central bank might stop its tightening cycle, which is the most aggressive since the 1980s, after delivering just one more rate hike in March.

Goldman Sachs said it continued to expect two more 25-basis-point hikes in March and May, while Morgan Stanley on Friday changed its forecast for the so-called terminal rate to 4.875% from 4.75%.

The Fed's policy rate is currently in the 4.50%-4.75% range.

According to CME Group data, the probability of a 25-basis-point hike at the Fed's March 21-22 policy meeting rose on Friday to around 95% from 83% just before the release of the jobs report. Those betting that the Fed might cut rates later this year also lost some conviction, with fed funds futures traders now expecting the policy rate to go down to 4.7% in December. Earlier this week, they anticipated a rate of 4.49%.

"The report will make insurance cuts less likely as there are no material signs of stress to force a rate cut," said Alexandra Wilson-Elizondo, head of multi-asset retail investing at Goldman Sachs Asset Management.

"The data today reinforces our positioning where we continue to be cautious on risk as the inflation question is slowly coming back into the investment narrative," she said.

(Reporting by Davide Barbuscia; Editing by Ira Iosebashvili and Paul Simao)