OIL PRICES soared close to $138 and the dollar slumped yesterday as the largest one-month rise in the US unemployment rate for 22 years tempered expectations of US interest rate rises this year.

The dollar had stabilised recently as markets priced in a US rate rise by the end of the year, but the May employment report forced investors to rethink their positions. This sparked a fall in the dollar and a surge in dollar-denominated commodities such as oil and gold. Stocks fell sharply in Europe and the US as investors worried about a vicious cycle in which dollar weakness fuels higher oil prices, and rising energy costs further slow economic growth.

Alan Ruskin, strategist at RBS Greenwich Capital, said: "Dollar weakness and the rise in oil prices is very negative for the US and global economy. High oil prices are affecting parts of the world, such as Asia, that the credit crunch could not reach."

Crude futures rose almost $10 to nearly $138 a barrel, after a gain of $5.49 on Thursday. The euro rose 0.9 per cent to $1.5731. The S&P 500 was down 1.8 per cent in afternoon trading after the FTSE Eurofirst 300 fell 2 per cent.

The US unemployment rate hit 5.5 per cent in May, up from 5 per cent in April as the economy lost 49,000 jobs. It was the largest monthly change since February 1986 when the rate also rose half a percentage point.

"I've been convinced that the unemployment rate was headed toward 6 per cent but I didn't expect to get half way there in one day," said Jay Mueller, economist at Wells Fargo. "The Fed [ Federal Reserve] does not tighten when the unemployment rate is rising. A 2 per cent Fed Funds rate may prevail for quite some time."

The employment report was the second blow for the dollar this week. On Thursday, the European Central Bank strongly indicated it would raise rates this summer due to inflation worries, triggering fresh dollar selling and higher oil prices. The dollar had rallied this week when Fed chairman Ben Bernanke expressed concern over the dollar feeding higher import prices and consumer inflation.

Economists blamed part of the jump in US unemployment on students looking for summer jobs, but it was still higher than expectations of a rise to 5.1 per cent.

Although the decline in jobs last month was slightly better than the 60,000 job losses predicted, the revised data for previous months showed 15,000 more jobs were lost.