Traders bet Fed will start raising rates next July

(Reuters) - The Federal Reserve's first round of interest-rate increases in a decade could start as soon as July, traders were betting on Friday, after a jump in jobs growth last month boosted confidence in the staying power of the U.S. recovery.

U.S. short-term interest-rate futures contracts plunged as traders priced in higher rates next year on the strength of a government report showing employers added 321,000 jobs last month, the most in nearly three years.

"This supports the view that the Federal Reserve will start hiking rates in the middle of next year,” said Mohamed El-Erian, chief economic advisor at Allianz in Newport Beach, Calif.

Rate-futures contracts now show that traders see about a 53 percent chance that the first Fed rate hike will come in July 2015, based on CME FedWatch, which tracks rate hike expectations using its Fed funds futures contracts. Before the report traders had not expected a first rate rise until September.

The Fed has kept short-term U.S. interest rates near zero since December 2008, and bought trillions of dollars of Treasuries and housing-backed securities to push borrowing costs down further and lift the economy.

In October, the Fed wound down its bond-buying stimulus in a nod to a stronger labor market, but still pledged to keep rates where they are for a "considerable time" to allow the recovery more traction. When they next meet Dec. 16-17, hawkish policymakers concerned that a stronger labor market could augur unwanted inflation may redouble their efforts to take the pledge out and pave the way for an earlier rate rise.

“This employment report, together with the upbeat assessment of labor markets contained in the Beige Book earlier this week, increases significantly the probability that the (Fed) will start raising the fed funds rate in the next six months," said Jim Kochan, chief fixed-income strategist at Wells Fargo Funds Management LLC in Menomee Falls, Wisc.

Added to other recent strong economic data, including manufacturing and car sales, the report "will give ammunition to those (Fed) members who would prefer a ‘normalization’ of monetary policy sooner rather than later.”

Friday's data showed hourly wages rose just 2.1 percent, a bit faster than they had been tracking but well below the 3 percent to 4 percent that Fed Chair Janet Yellen has said would reflect a healthy economy.

Fed policymakers want to see signs that inflation is on its way back up to their 2-percent target, and are watching the wage data closely.

Policymakers will submit new economic forecasts at the policy-setting meeting, although it is unclear how much Friday's report will change those.

"It's a strong report and we've seen that trend. I think the economy is coming back," Cleveland Fed President Loretta Mester told reporters, adding she would not adjust her forecasts based on it. "I was pleased to see that strong a number and the economy is moving in the right direction."

Mester said she expects the Fed to raise rates some time in 2015, a view that nearly all her fellow policymakers share.

(Reporting by Ann Saphir, Jonathan Spicer and Jennifer Ablan; Editing by Chizu Nomiyama and W Simon)