Fed poised to raise key interest rates: Bonds tumble after stronger than expected growth in US employment

US STOCKS and bonds tumbled yesterday, pulling UK bonds down in their wake, after stronger than expected growth in US employment put the markets on red alert for another rise in US interest rates.

There were general predictions that the key US Fed Funds rate could be lifted as much as half a point to 4.25 per cent while the discount rate could be raised by half a point to 3.5 per cent - the first increase in five years.

The latest indication of robust US growth drove long-dated US Treasury bonds down by almost 2 points and lifted yields above 7.50 per cent for the first time in 17 months. The yield on three-month US Treasury bills, which are sensitive to changes in short-term rates, rose to 4.18 per cent, the highest for over two years. In London the price of the long gilt future fell by more than pounds 1 while some cash gilt prices lost pounds 1.50.

The interest rate fears, which resurfaced earlier this week after the dollar sank sharply, sent Wall Street stock prices reeling.

At one stage yesterday afternoon in New York, the Dow Jones Industrial Average dropped 50 points, but it bounced back in late trading to close at 3,669.50, down 26.47 points. The slump came too late to affect UK share prices. The FT-SE 100 Index ended unchanged at 3,106.0 after a see-saw performance during the day.

The unexpectedly strong April unemployment report suggests the US economy is once more picking up speed and that an inflation-conscious Federal Reserve may be quickly forced to raise interest rates again.

The jobless figures from the Labour Department showed unemployment at 6.4 per cent, down from 6.5 per cent in March and 6.7 per cent at the start of the year. But the biggest impact on jittery financial markets came from last month's 267,000 new jobs created outside the farm sector. Although this was far below the six-year record of 456,000 new jobs in March, it was far more than most economists had predicted.

The increase may come around 17 May, the next scheduled meeting of the central bank's policy-making Federal Open Market Committee. The Fed has already nudged up short term rates by 0.75 per cent in three separate quarter-point instalments since February. A further tightening almost certainly would involve an increase in the discount rate, which has remained at 3 per cent since December 1991.

The jobless report indicates that, after an early year slowdown caused by icy weather and the California earthquake, the US economy is once more moving solidly ahead, at an annual rate of over 3 per cent.

The best gains came in the service and retail sectors. But more than 67,000 new jobs were added in the construction industry, sign of renewed growth in one of the economy's key areas. Manufacturing industry showed only a tiny gain of 3,000 jobs. But the increase was for the seventh successive month, and was achieved despite the Teamster Union strike, which idled 70,000 truck-drivers and dock workers.

The prospects for further advances are good. The average working week now stands at a post-war high of 42.2 hours, suggesting that employers will have to start taking on new workers, rather than expanding overtime and relying on part-time labour to meet factory demand.

Despite the threat of higher rates, which could be lifted as early as next week, and heavy central bank support for the US currency earlier this week, the dollar faltered towards the close. That suggests the US currency is unlikely to find support until after the US Federal Reserve raises rates.

After trading up to DM1.6765 the US currency fell back to a closing DM1.6630, a shade below Thursday night's finish. Kit Juckes of Warburg Securities said: 'The dollar is still soaking up good news like a sponge with little noticeable effect.'

Sterling performed better than feared despite the Tory defeat in the local elections. It closed one pfennig lower at DM2.4857 and was slightly weaker against the dollar, at dollars 1.4920.