June 5 (Bloomberg) -- Traders are beginning to price in expectations the Federal Reserve will raise interest rates this year as the recession shows signs of abating.

Federal-funds futures contracts on the Chicago Board of Trade show a 70 percent probability the central bank will lift its target rate for overnight bank borrowing to at least 0.5 percent by November after a report today showed the U.S. economy shed the fewest jobs in May in eight months. Rate-increase odds were 27 percent yesterday.

The Fed cut the target rate to the record low range of zero to 0.25 percent in December as the economy lapsed into the worst recession in decades. President Barack Obama and Fed Chairman Ben S. Bernanke have committed $12.8 trillion to thaw frozen credit markets and ramped up government spending to revive growth. The Fed last raised borrowing costs in June 2006, when policy makers pushed the rate to 5.25 percent.

“The market is pricing in some kind of action by the Fed by the end of the year,” said Lou Brien, a strategist at Chicago- based DRW Trading Group, which uses its own capital to make markets on interest-rate derivatives. “The payroll number -- which is really what we always trade off of -- was quite a bit stronger than expected. You get knee-jerk reactions to data like this.”

Eurodollar Futures

Implied yields on eurodollar futures as well as fed-fund futures contracts, both used to speculate on changes in central- bank policy, surged today, with further-deferred contracts posting the largest increases. The yield on the December 2009 eurodollar contract rose 34 basis points today to 1.35 percent, while the December fed-funds futures contract yield increased 23 basis points to 0.57 percent. A basis point is 0.01 percentage point.

Payrolls fell by 345,000 in May, the Labor Department said in Washington. The unemployment rate rose to 9.4 percent, the highest since 1983. Payrolls were forecast to drop by 520,000 last month, according to the median of 76 economists surveyed by Bloomberg News.

Yields on two-year Treasuries increased 35 basis points to 1.31 percent, the biggest one-day increase since September. The price on the benchmark 0.875 percent note maturing in May 2011 fell 21/32, or $6.56 per $1,000 face value, to 99 6/32, according to BGCantor Market Data.

‘No Evidence’

“Although the Fed is looking for exit strategies, I don’t think anyone at the Fed is anywhere near contemplating raising rates,” said Gavin Friend, a markets strategist in London at National Australia Bank Ltd. “There is no evidence so far that quantitative easing is fueling inflation.”

Yields implied by eurodollar futures are based on expectations for the three-month dollar London interbank offered rate, or Libor. The contracts trade in price terms and are sometimes used to bet on the direction of central-bank rates.

The difference, or spread, between the implied yields on the eurodollar futures contract that expires in September and the contract due in September 2010 surged 39 basis points to 137 basis points, its widest this year, showing traders are pricing in increases in rates next year.

“I am not overly concerned about the inflation threat,” Federal Reserve Bank of Atlanta President Dennis Lockhart said, Market News International reported today, citing an interview. The economy is likely to operate below its potential growth rate “for quite a period of time going into next year and perhaps the year after, and so my sense is that we need to manage the package of stimulus to be supportive of a recovery.”

To contact the reporter on this story: Liz Capo McCormick in New York at Emccormick7@bloomberg.net

Last Updated: June 5, 2009 15:19 EDT