* Traders see no more than 40 pct chance of rate hike in Sept.
* U.S. fed funds rate reaches highest since April 2013
* Dollar Libor falls from highest level since Oct. 2012
By Richard Leong
NEW YORK, Aug 12 (Reuters) - Traders on Wednesday scaled back further their bets that the U.S. Federal Reserve would increase interest rates this year after China devalued its currency for a second day in an effort to help its exporters.
Short-term U.S. interest rates markets signaled traders see no more than a 40 percent chance the U.S. central bank would raise rates at its Sept. 16-17 meeting.
Following a solid July jobs reports last Friday, traders had priced in just above a 50-percent probability Fed policymakers would be in favor of raising its target on the federal funds rate from a zero to 0.25 percent range.
The surprise move from Beijing dropped the yuan to a four-year low. It roiled financial markets as traders bet a weaker yuan would re-ignite disinflation pressure globally, making it tougher for the U.S. economy to achieve the Fed's 2 percent inflation target, analysts said.
"That has made a huge impact on people's thinking. I'm less inclined to believe that the Fed would move in September, but I'm still sticking to it," said Ellis Phifer, a market strategist at Raymond James in Memphis.
Fed funds futures implied traders see a 39 percent chance of a rate increase in September and a 66 percent chance in December, according to CME Group's FedWatch program.
This compared with 45 percent chance in September and 71 percent chance in December on Tuesday.
In the overnight indexed swaps (OIS) market, the decline in overnight borrowing costs suggested traders reduced their expectations on a September Fed rate hike to 40 percent, down from 43 percent on Tuesday, according to Tullett Prebon data.
As traders pared their rate-hike bets in derivatives, overnight borrowing costs in the cash market were mixed.
The fed funds rate, which banks charge each other to borrow excess reserves, averaged 0.15 percent on Tuesday, the highest level since April 2013. It was last quoted at 0.13 to 0.14 percent, according to ICAP.
In the repurchase agreement sector, the cost for overnight loans which bond dealers use to borrow overnight cash from money market funds and other investors, was quoted at 0.28 to 0.29 percent, above Tuesday's 0.26 percent, according to ICAP .
The London interbank offered rate for three-month dollars fell to 0.30930 percent from Tuesday's 0.31435 percent, the highest since October 2012.
Libor is a global rate benchmark for about $350 trillion worth of financial products worldwide. (Reporting by Richard Leong; Editing by Nick Zieminski)