Fed rate cuts gone - a hike may be coming

NEW YORK (CNNMoney.com) -- What a difference a few weeks make.

As recently as last month many investors on Wall Street were still hoping the Federal Reserve would cut interest rates later this year in order to jump start flagging economic growth.

But just a handful of economic reports later, the signals are flashing that not only are rate cuts off the table - but that there's a chance the central bank may actually have to raise rates again before the year is out.

The latest flurry of economic numbers - from readings on the services sector to the latest on the job market - have all pointed to a pickup in the economy after growth in the first quarter slowed to the weakest pace in five years.

Exhibit one on what's next for rates: the Treasury bond market, where traders have bid up long-term bond yields as they bet that the Fed won't cut rates - and that the central bank may actually have to tighten credit later this year if the economy - and inflation - pick up.

The yield on the benchmark 10-year note jumped as high as 4.99 percent Tuesday, according to Reuters, just shy of 5 percent, a level not scaled since August 2006. Bond prices and yields move in opposite directions.

Meanwhile, stock prices tumbled as investors worried about possible rate hikes took a negative view of the recent reports of stronger economic growth - and used the news as an excuse to sell after the market's recent record-setting rally.

While first-quarter economic growth came in at a 0.6 percent rate, the slowest since 2002, Federal Reserve Chairman Ben Bernanke said Tuesday that the economy should grow at a "moderate" pace in the next few quarters, strengthening the belief that rate cuts were less likely.

Speaking to a South African conference via satellite, Bernanke said that despite ongoing weakness in the housing market, the economy should "advance at a moderate pace, close to or slightly below the economy's trend rate of expansion" - which economists estimate is about 2.5 to 3.5 percent.

The latest readings have pointed to a pick-up in the economy. On Tuesday, the Institute for Supply Management said its services index jumped to 59.7 in May from 56 in April. That surprised economists who had expected a decline to 55.5.

While much younger than the ISM's closely followed manufacturing index, the report offers a broader view of the economy since it includes the service sector, which accounts for about three-quarters of U.S. economic activity.

Unexpected strength in the services sector comes on the heels of a barrage of reports released last week that pointed to solid growth in the job market, manufacturing and consumer spending.

What do the signs of the economy righting itself mean for future Fed policy?

Wall Street powerhouse Goldman Sachs (Charts, Fortune 500) said Tuesday it no longer expects the Fed to cut rates this year - or even in 2008. Earlier, the investment bank's economists had forecast the central bank would start cutting short-term rates in September. (Full story)

Scott Anderson, senior economist at Wells Fargo, thinks the central bank's policymakers will hold rates steady when they next meet on June 27-28. "The Fed remains comfortably on the sidelines," he said in a note. "For the June FOMC meeting, we expect no rate hike or rate cut."

But he added that inflation could rebound along with the economy, which could push so-called core inflation - excluding often volatile food and energy prices - back above the Fed's unofficial comfort zone of 1 to 2 percent. That would nearly assure another rate hike from the Fed, according to Anderson.

Fed officials have said the risk that inflation fails to moderate as expected remains their predominant policy concern, and Bernanke said Tuesday that while core inflation has ebbed, it still remains somewhat elevated.

On Wall Street, concerns that rising inflation would eventually force the Fed to boost rates sent stocks tumbling. The Dow industrials tumbled as much as 125 points at one point during the session. The 30-share Dow was off about 80 points at the close.

Interest rate futures traded in Chicago show traders are betting there's nearly a 40 percent chance the Fed will raise rates by the year-end - a possibility practically unheard of as recently as a month ago, according to Harris Private Bank.

But some on Wall Street think a rate hike won't come until late this year, if it comes at all.

Core inflation already has peaked and is starting to fall into the Fed's target zone, noted Michael Cheah, portfolio manager at AIG SunAmerica Asset Management, who doesn't think a rate hike is likely.

"It's very difficult to believe the Fed will raise rates given how the economy is still trying to work through the fallout of the housing sector," he said.