(Updates market action, adds quote)
By Richard Leong
NEW YORK, May 29 (Reuters) - U.S. interest rates futures rallied on Tuesday as traders slashed their expectations that the Federal Reserve would raise key overnight borrowing costs three more times in 2018 as Italy’s political turmoil threatens European economic growth.
The political turmoil propelled two-year Italian bond yields to their highest levels since late 2013 and knocked the euro to an 11-month low. Investors dumped U.S. and European stocks in favor of the yen, U.S. and German government bonds and other lower-risk assets.
The anti-establishment 5-Star Movement and the far-right League, the biggest winners from inconclusive Italian elections in March, abandoned plans to form a coalition government this week after Italian President Sergio Mattarella vetoed their choice for economy minister, a euroskeptic who supports the euro zone’s third-biggest economy leaving the single currency.
Fears of another election would undermine investor confidence and exacerbate slowing growth across the economic bloc. That may cause the European Central Bank to abandon plans to end its 2.55 trillion euro bond purchase program in September.
If the ECB extends its stimulus plan, it would diminish the likelihood that the Fed would squeeze in three more rate increases this year, analysts said.
“If the ECB feels Italy is heading into a crisis, the Fed will back off quickly,” said Ellis Phifer, senior market strategist at Raymond James in Memphis.
The U.S. central bank is still on track to raise short-term interest rates by a quarter point, to 1.75-2.00 percent, at its June 12-13 meeting, as the domestic jobs market remains solid and inflation seems to be firming toward the Fed’s 2 percent goal, Phifer said.
“The economy justifies one more hike in June,” said Gregory Daco, head of U.S. macroeconomics at Oxford Economics in New York. “They can assess the situation later this summer. The Fed has the luxury to wait.”
Federal funds futures implied traders saw a 74 percent chance the U.S. central bank would raise key short-term interest rates in two weeks, down from 90 percent late on Friday and 100 percent a week earlier, according to CME Group’s FedWatch program.
U.S. financial markets were closed on Monday for the Memorial Day holiday.
Fed funds futures signaled traders see a 13 percent chance the Fed would raise key short-term interest rates to 2.25-2.50 percent by year end . That is below the 32 percent chance seen late Friday and 51 percent a week earlier, FedWatch showed. (Reporting by Richard Leong Editing by Meredith Mazzilli and Leslie Adler)