More investors are betting that the Federal Reserve will raise short-term interest rates as soon as June, shrugging off signs that the U.S. economy is reverting to sluggishness following a strong second half of 2014.
The value of certain derivatives that would benefit from rising U.S. rates last week was the largest in three months at $ 244 billion, said Cheng Chen, U.S. rates strategist at TD Securities. The value of these so-called eurodollar shorts more than quadrupled from $ 55 billion in the previous week, though the net bet on rising rates in that market remains a fraction of last summer's $ 1.9 trillion high.
Eurodollar futures are a popular tool for investors seeking to hedge against rising rates or to speculate on the path and timing of Fed policy. An investor shorting eurodollars sells a futures contract, betting that rising rates will reduce the value of the contract and allow him or her to repurchase it later at a lower price.
While investors broadly expect the Fed this year to raise its federal-funds overnight bank-lending target rate for the first time since 2006, the timing of that move has been clouded by a surge by the U.S. dollar, concerns about economic growth around the globe and fresh signs that the U.S. expansion is slowing.
"The Fed has to move slowly or it runs the risk of destabilizing global financial markets with a surging dollar,'' said Ward McCarthy, chief financial economist in the fixed-income group at Jefferies LLC.
Fed officials are widely expected to alter the guidance they give the public about interest rates at their two-day policy meeting this week, dropping an assurance they will be "patient" in deciding when to start raising rates.
The change will formally open the door to a possible rate increase in June, but Fed officials aren't set on acting then. Fed Chairwoman Janet Yellen has said she doesn't want to start moving rates up until officials are "reasonably confident" that inflation is heading back toward the Fed's 2% goal after running below it for 34 months running.
"Until inflation becomes a real live event, investors will likely look away from the fear" that the Fed may raise interest rates in June, said Kevin Giddis, head of fixed income at Raymond James in Memphis, Tenn. "The Fed wants to move away from zero-rate policy, but the question remains when."
There are signs that other investors see the Fed standing pat in June. Fed-funds futures, used by investors and traders to place bets on central-bank policy, showed Monday that investors see an 18% likelihood of a rate increase in June, compared with 23% a month ago, according to data from the CME.
"I still look for the first [rate increase] to come in September,'' said David Kotok, chairman and chief investment officer of Cumberland Advisors in Sarasota, Fla., which manages about $ 2.3 billion. "The Fed is uncertain about the strength of the dollar and whether it will be slowing the rate of economic growth in the U.S."
The latest red flags came Monday with reports showing weakness in U.S. industrial production and housing. Overall U.S. industrial output rose 0.1% last month, the Fed said, but the gain was attributed to cold weather driving up demand for heating.
Manufacturing output fell for the third straight month, indicating the surging dollar and global economic woes are weighing on factories. Mining production continued to slide as energy companies rein in drilling amid depressed oil prices.
Meanwhile, a measure of home-builder confidence fell for the third straight month in March, the National Association of Home Builders said Monday.
Central banks in China, Australia, Denmark, Korea and Russia have cut interest rates this year in response to sluggish domestic economic growth. The European Central Bank started its bond-buying program last week in a bid to fend off fears of deflation, an economically enervating cycle of falling spending, wages and prices.
A stronger dollar has attracted foreign buyers toU.S. Treasury bonds, keeping long-term borrowing costs low for U.S. consumers and businesses. But as the dollar rises and other currencies fall, it reduces U.S. exporters' competitiveness in global trade and makes it harder for the Fed to push inflation toward its target.
The roaring dollar also is rippling through the global economy. Capital flight out of emerging markets has put strains on some countries that rely heavily on foreign money for economic growth. Many companies in developing countries have borrowed cheaply in dollars in recent years. Now a higher dollar makes those loans costlier, hurting earnings and raising default risks.
Justin Lederer, senior trader of interest rates at Cantor Fitzgerald LP in New York, said he expects the Fed to raise rates in June. But he said this tightening cycle will be "slow and gradual," unlike 2004-2006, when the Fed raised rates 17 meetings in a row.
Eric Green, head of rates and economic research at TD Securities, said unlike 2004, the dollar this time will reinforce the transition to less accommodative financial conditions. It means "less heavy lifting by the Fed" and a lower fed-funds target rate this time compared with previous cycles when the tightening ends, he said.
—Josh Mitchell contributed to this article.
Write to Min Zeng at min.zeng@wsj.com
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