Bank of America strategists are signaling that investors should prepare for the possibility of the Federal Reserve lifting its benchmark interest rate back above 5%, a scenario markets have yet to fully price in.
The team, led by Mark Cabana and Meghan Swiber, argues that interest rate markets are still underestimating the endpoint of the tightening cycle that began this week. They are urging clients to position for further upside in two-year Treasury yields.
Currently, interest rate swaps imply three additional 25-basis-point hikes, which would push the effective federal funds rate into the 4.5%-4.75% range. However, BofA contends that overnight borrowing costs could revisit the highs of the 2022-2023 tightening cycle, when the target rate peaked at 5.5%.
The strategists forecast two-year Treasury yields will climb to 5% this year, up from roughly 4.7% on Friday, a projection that diverges sharply from the consensus view.
The BofA team noted that Chairman Kevin Warsh's characterization of Wednesday's rate hike as removing "a dose of accommodation" suggests officials do not yet view monetary policy as a drag on the U.S. economy.
"A Fed that does not view policy as restrictive could keep raising rates until financial conditions genuinely become restrictive, which reinforces our conviction on a flatter yield curve," the strategists wrote in a report.
Alongside their latest forecasts, they are recommending clients short two-year Treasuries with a target yield of 5.25%, a level near the 2023 high. While Warsh carefully avoided committing to any subsequent moves, he reiterated his dissatisfaction with the inflation trajectory and emphasized the Fed's commitment to price stability.
In recent trading sessions, the yield curve has already been flattening, with short-end rates rising faster than long-end rates as traders increase their bets on further Fed tightening.
These strategists, who cover the bond market and identify trading opportunities for clients, operate separately from BofA's economist team, which focuses on central bank research.
In a report released Wednesday, BofA's U.S. economist Aditya Bhave said his team maintains its call for two additional rate hikes this year, in October and December, and anticipates no policy action in 2027.
BofA strategists also pointed to the Fed's latest Summary of Economic Projections, which shows officials view upside risks to inflation as far greater than risks to unemployment.
They further cited a Taylor rule calculation — a widely used formula that generates a suggested policy rate based on deviations of inflation and economic output from their target levels — which implies the federal funds rate should be around 5.3%.
"Simple frameworks suggest the federal funds rate should be above 5%," they said. "While front-end yields can continue to rise, we expect more limited transmission to longer maturities."
They project the 10-year Treasury yield will end the year at 5%, close to Monday's trading level.
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