US RATE FUTURES-Debt plan smacks down Fed rate cut views

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By Ros Krasny

CHICAGO, Sept 19 (Reuters) - Plans announced on Friday for a massive taxpayer-funded clean-up of toxic debt that has swamped the U.S. financial system quickly reshaped the landscape for Federal Reserve interest rate policy.

The market's belief that the Fed would lower interest rates in October to plug holes in the credit market and shore up a struggling economy was overtaken by bets that rate policy will be kept on hold until well into 2009.

By day's end, short-term interest rate futures, which handicap views on Fed policy, showed just a 20 percent chance that the Fed will trim its benchmark lending rate in October after fully pricing a rate cut for much of the week.

After one of the most dramatic few days in the history of Wall Street, prospects for a change at the Oct. 28-29 Federal Open Market Committee meeting are back to the same level from a week ago.

Futures lean toward a hike in the fed funds rate, to 2.25 percent, by the March FOMC meeting and fully price a rate hike by June.

"To say the past week was a wild ride was an understatement. It was more like being handcuffed to a roller-coaster until the authorities found where the emergency brake was," said Rudy Narvas, analyst at 4CAST Ltd. in New York.

The Treasury's rescue plan for struggling money market mutual funds reversed huge flight-to-quality buying in short-dated Treasury debt and sent U.S. stock markets to a second straight day of huge gains -- all of which eroded the perceived need for the Fed to lower interest rates.

"Rome was burning and the barbarians were at the gates of the U.S. financial system, and three horsemen rode to the rescue," said strategists at Action Economics.

Inflation levels reflected in the spread between Treasury inflation protected securities and conventional Treasury yields also reversed course from Thursday's multi-year lows, eroding beliefs that the FOMC will be prepared to lower rates this year. (Editing by Leslie Adler)