Investors are betting that the US Federal Reserve will ease monetary policy as soon as next month, after a top official at the central bank admitted that market signals indicated that interest rates might be “inappropriately high”.

The Fed has planned to hold its current interest rate corridor steady at 2.25 per cent to 2.5 per cent through 2019, but investors have increasingly been speculating that slower economic growth could force it to cut rates before the end of the year.

Those expectations have been fanned by the US government’s recent decision to open up a two-front trade war with China and Mexico, leading economists to sharply mark down their forecasts for economic growth this year.

Most policymakers have been wary of talking up the prospects of rate cuts, but on Monday James Bullard, head of the St Louis Fed and a voting member of the policy-setting Federal Open Market Committee, said lower interest rates might be “warranted soon”, citing trade war risks, slowing global growth and the lack of inflationary pressure in the US.

“The FOMC faces an economy that is expected to grow more slowly going forward, with some risk that the slowdown could be sharper than expected due to ongoing global trade regime uncertainty,” Mr Bullard said in a speech. “In addition, both inflation and inflation expectations remain below target, and signals from the Treasury yield curve seem to suggest that the current policy rate setting is inappropriately high.

“A downward policy rate adjustment may be warranted soon to help re-centre inflation and inflation expectations at target and also to provide some insurance in case of a sharper-than-expected slowdown,” he argued.

The comments sent a jolt through the Treasury market, with the interest rate-sensitive two-year US government bond yield tumbling another 7 basis points to a one-and-a-half year low of 1.86 per cent.

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In mid-November it peaked at nearly 3 per cent, and it stood at about 2.5 per cent just a few months ago. The recent rally is the strongest since October 2008. The 10-year Treasury yield declined 6bp and is flirting with the 2 per cent mark for the first time since mid-2017.

Traders are now for the first time betting that there is a greater-than-even probability that the Fed will trim interest rates as soon as its July meeting, according to Fed funds futures — derivatives contracts that investors use to wager on or hedge against interest movements. At the start of May, the Fed funds futures market indicated only a 19 per cent chance of a cut in July.

Moreover, these interest rate derivatives indicate that investors see no chance of the Fed staying on hold through 2019, and that the most likely outcome is that the central bank cuts interest rates at least twice this year. There is even a 15 per cent implied chance of four cuts, according to Bloomberg calculations.

Mr Bullard is considered one of the Fed’s dovish members, but his comments are still notable as they mark the first time a Fed official has explicitly said a rate cut may be needed this year.

Richard Clarida, the Fed’s vice-chair, said last week that the Fed was “very attuned” to the looming risks and vowed that the central bank would be “nimble” in ensuring that the US economic expansion continued, but stopped short of indicating that a rate cut was coming soon.

JPMorgan now sees a 43 per cent chance the US will enter a recession over the next 12 months — and predicts rate cuts in September and December — while Morgan Stanley on Monday warned the US market cycle had shifted from an expansionary phase to a “downturn” for the first time since 2007. Sentiment was not helped by disappointing data out on Monday on US manufacturing activity.

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Via Financial Times