Bank of America Warns Fed May Push Rates Above 5%, Recommends Shorting 2-Year Treasuries

Bank of America strategists are warning that investors should prepare for the risk of the Federal Reserve pushing its benchmark interest rate back above 5%. The team argues that interest rate markets are underestimating the ultimate peak of the current hiking cycle, a view that runs contrary to current market consensus.

A Hawkish Rate Forecast

A BofA team led by strategists Mark Cabana and Meghan Swiber stated that the fed funds rate could potentially revisit the 5.5% high reached during the 2022-2023 tightening cycle. This contrasts with current pricing in interest rate swaps, which implies a peak in the 4.5%-4.75% range.

In line with this outlook, the strategists forecast the 2-year Treasury yield will climb to 5% by the end of the year, up from its current level of approximately 4.7%. They noted that recent Fed commentary suggests officials do not yet view monetary policy as restrictive enough to significantly slow the U.S. economy.

Rationale and Trade Recommendation

The strategists recommended that clients short the 2-year U.S. Treasury note, targeting a yield of 5.25%, which would be near its 2023 peak. They argued that "a Fed that doesn't see policy as restrictive, may keep hiking until financial conditions are truly restrictive," a scenario that reinforces their conviction in a flattening yield curve, where short-term rates rise faster than long-term ones.

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Their analysis is supported by several factors:

• The Fed's latest Summary of Economic Projections (SEP) indicates officials see greater upside risks to inflation than to unemployment.
• An application of the Taylor rule, a formula used to suggest an appropriate policy rate, implies the fed funds rate should be around 5.3%.

Contrasting Views and Market Impact

It is important to note that this call comes from BofA's market strategy team, which identifies trading opportunities, and is distinct from the bank's economics department. In a separate report, BofA U.S. economist Aditya Bhave's team maintained its forecast for two more rate hikes this year, in October and December, but projected no policy action in 2027.

While the strategists see significant room for short-term yields to rise, they expect a more limited impact on the long end of the curve. They forecast the 10-year Treasury yield will end the year at 5%, close to its current trading level.