BofA warns markets are underpricing Fed tightening, says rates could top 5%

Bank of America has warned that investors should prepare for the possibility that the Federal Reserve could raise its benchmark interest rate back above 5%, saying financial markets are significantly underestimating how high the Fed will ultimately push rates.

According to Bloomberg and other outlets, BofA strategists Mark Cabana and Meghan Swiber said in a report Friday (local time) that the Fed could lift rates to levels comparable to its 2022–2023 tightening cycle, when the upper bound of the federal funds rate soared to 5.5%.

BofA said markets are underpricing the terminal rate for the Fed's current rate-hike cycle and recommended that investors position for further upside in the 2-year US Treasury yield in particular.

Interest rate swap markets currently reflect expectations for three more Fed rate hikes, which would bring the effective federal funds rate to around 4.5–4.75%. The 2-year Treasury yield stood at approximately 4.7% as of Friday.

BofA's fixed income strategy team, however, left open the possibility that the Fed could tighten more aggressively than markets expect.

"The Fed does not currently view monetary policy as restrictive and is likely to keep raising rates until financial conditions become meaningfully tighter," the report said.

In that scenario, the report projected a pronounced flattening of the yield curve, with short-term rates rising sharply while the increase in long-term rates remains relatively limited.

BofA specifically forecast that the 2-year Treasury yield could climb to 5.25%, matching the peak it hit in 2023. The bank also said that even a fundamental economic analysis points to a higher appropriate Fed rate than markets currently anticipate.

Applying the Taylor Rule — a formula that estimates the appropriate policy rate based on how far inflation and economic output deviate from their targets — the report said the federal funds rate should stand at around 5.3%.

"Short-term Treasury yields could continue to rise, but the spillover to longer maturities will be limited," the report said, adding that the 10-year Treasury yield is expected to remain around its current level of 5% through year-end.

Bloomberg noted that the team behind the report analyzes bond markets and advises clients on investment strategy, and is a separate unit from the economists who focus specifically on Fed analysis.

BofA's US economist Aditya Bhave, in a separate report Wednesday, maintained his existing forecast that the Fed would raise rates twice more this year — once each in October and December.