Business activity in the U.S. services sector fell in January for the first time in nearly five years, stirring up fears of economic woes south of the border.

The non-manufacturing business activity index contracted sharply, falling to 41.9 from 54.4, the first contraction since March 2003, according to the Institute for Supply Management’s index that measures the sectors’ activity. The index’s level was well below the average of 48.1 seen in the last recession.

Weakness permeated the report, as the new orders index dropped to 43.5 from 53.9, while the employment index also collapsed, falling to 43.9 from 51.8. The prices index, however, remained elevated at 70.7 and the new export orders index increased to 52 from 50.

The combination of further housing market deterioration, volatiliy in equity markets and weak employment led TD Economics to downgrade its outlook for the U.S. economy today.

“With the economic slowdown now making its way to employment growth, the prospects for consumer spending have become more precarious,” said TD in an updated economic outlook today. It is now expecting U.S. growth to come in at 1.6% for 2008 and then improving to 2.2% next year.

Economists at BMO Capital Markets say today’s service sector activity numbers suggest further interest rate cuts are on the way in the U.S. “The ISM non-manufacturing survey, which measures almost nine-tenths of economic activity, provides compelling evidence (along with the decline in payrolls and a 6% slide in auto sales in January) that the U.S. economy is in recession,” wrote Sal Guatieri, senior economist at BMO, in a note. “The odds of another hefty Fed rate cut in March just went up… waaaay up.”

RBC economists agree rate reductions are coming down, and expect the Fed to cut fund rates by 100 basis points to 2% by April. “The weakness in the non-manufacturing index and the business activity index both suggest that the Fed will continue to act aggressively in order to stave off a more severe downturn,” wrote Rishi Sondhi, economist at RBC, in a note after today’s ISM announcement.

According to the new index, only three non-manufacturing industries reported growth in January. The institute said members’ comments in January indicate that weakness in the economy coupled with increased costs have negatively affected their business. They also indicated they are experiencing inflationary pressures. “The overall indication in January is that non-manufacturing has come to the end of a long-term period of growth and has contracted for the month of January,” said the institute, in a release.