UPDATE 2-Traders see odds favoring September 2014 Fed rate hike

Fri Jul 5, 2013 11:18am EDT

By Ann Saphir

SAN FRANCISCO, July 5 (Reuters) - Futures traders are betting the U.S. Federal Reserve will start raising its key policy rate in little over a year, even though that is months before most Fed policymakers themselves expect to do so.

After a government report earlier on Friday showed the U.S. economy added 195,000 jobs in June, topping analysts' forecasts, futures traders priced in as much as a 58-percent chance of a September 2014 rate hike, based on fed funds futures trading at CME Group Inc.

By late morning, they had pared back their view of a September 2014 rate hike to a 52-percent probability and gave a rate hike at the October 2014 meeting a 62-percent chance.

The Fed has kept short-term interest rates near zero since December 2008.

Nonetheless, even October 2014 is at least three months earlier than most Fed policymakers expect a rate hike. Fifteen of the Fed's 19 policymakers in June had not expected to begin raising rates until 2015 or later.

Market anticipation of an earlier rate hike could prove a challenge for Fed policymakers if it leads to tighter financial conditions, making it harder for companies to borrow, and as a result, to hire.

Fed Chairman Ben Bernanke last month said the U.S. central bank could pare back its massive bond-buying program later this year and end it by the middle of 2014 if the economy continues to improve. Many observers saw today's report as more grist for that timeline.

"It really cements our view that the Fed will start to taper the size of its QE3 asset purchases in September," said Paul Dales, a London-based U.S. economist for Capital Economics.

But Dales also noted that Bernanke has sought to assure investors an end to the bond-buying program does not mean the Fed is keen on quickly ramping up borrowing costs.

"There's a world of difference between stopping providing extra stimulus to the economy, and actually taking away stimulus and tightening policy," Dales noted. "Higher interest rates are a story for 2015, not 2014."

The Fed has pledged to keep monetary policy easy even after the recovery takes hold, and as long as inflation stays contained, has vowed to keep rates low until the unemployment rate drops to at least 6.5 percent.

Friday's report showed the unemployment rate steady at 7.6 percent, as more people jumped back into job-seeking mode, swelling the labor force in a sign of growing confidence in the economic recovery.

That could mean the economy is a bit farther from 6.5 percent unemployment - and the possibility of a rate raise - than June's strong job growth might otherwise imply, Morgan Stanley economist Ted Wieseman said.

Wieseman also said he expects unemployment to fall to that key level in March 2015.

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