U.S. services sector activity jumps to 12-1/2-year high

By Lucia Mutikani

WASHINGTON (Reuters) - U.S. services sector activity raced to a near 12-1/2-year high in January, buoyed by robust growth in new orders, the latest sign of strong momentum in the economy at the start of the year.

Economic growth is showing strength even before the stimulus from a $1.5 trillion tax cut package, which came into effect last month, has started to filter through. That is causing concern that the economy could overheat.

The yield on the benchmark 10-year Treasury note has risen to a four-year high as investors anticipate a slightly faster pace of interest rate increases from the Federal Reserve than has been expected.

The U.S. central bank has forecast three rate increases this year after raising borrowing costs three times in 2017. The Institute for Supply Management's (ISM) survey on Monday added to a report on Friday showing a pickup in job gains in January and the strongest annual wage growth in more than 8-1/2 years.

"All of this is before the actual effects of the tax cuts have had time to kick in," said John Ryding, chief economist at RDQ Economics in New York. "The combination of strong employment growth and rising cost pressures will keep the Fed on course for a rate hike in March and we continue to believe the Fed will hike four times in 2018."

The ISM said its non-manufacturing activity index jumped 3.9 points to 59.9, the highest reading since August 2005. A reading above 50 indicates expansion in the sector, which accounts for more than two-thirds of U.S. economic activity.

New orders jumped 8.2 points to 62.7, the best reading since January 2011. Services industry respondents tied the surge in orders to the tax cuts and the strengthening economy. The survey's production index rose 2.0 points and a measure of services sector employment soared 5.3 points to a record high.

REASSURING SIGN

The bullish ISM survey, however, likely overstates the health of the economy. A separate survey from data firm Markit, showed its services sector PMI fell to a nine-month low in January. But the survey's new orders gauge rose last month.

The economy grew 2.3 percent in 2017 and is expected to hit the Trump administration's 3 percent target this year, before slowing in 2018.

Prices for U.S. Treasuries were trading lower, though the yield on the benchmark 10-year note backed off a four-year high. The dollar rose against a basket of currencies, while stocks on Wall Street fell.

"The ISM indices have been especially volatile in recent months, but January's release is a reassuring sign that the economy has continued to gather momentum at the beginning of 2018," said Michael Pearce, senior U.S. economist at Capital Economics in New York.

Respondents to the ISM survey offered an upbeat assessment of business for the first quarter. Finance and insurance industry executives reported "signs of strong growth (in) financial performance expectations given the recent tax changes."

Their professional, scientific and technical services counterparts said the "outlook continues to look bright for 2018." The survey also showed services industries paying more for materials, which fits in with expectations of higher inflation and interest rates this year.

"With the prices paid component of the ISM also continuing to trend higher in January, we think the Fed will be forced to step up the pace of policy tightening this year, delivering a total of four rate hikes," said Pearce.

Industries reported receiving more export orders. They also reported an increase in imports, which economists said could weigh on gross domestic product growth in the first quarter. Imports subtracted almost 2 percentage points from GDP growth in the fourth quarter.

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(Reporting by Lucia Mutikani; Editing by Chizu Nomiyama and Andrea Ricci)