Fed May Hike Benchmark Rate Above 5%: BofA Warns

▲ U.S. Federal Reserve

Bank of America (BofA) has warned that the U.S. Federal Reserve (Fed) must prepare for the risk of raising its benchmark interest rate above 5%.

In a report on September 19, local time, BofA strategists including Mark Cabana and Meghan Swiber projected that the Fed could raise benchmark rates up to the levels seen during the 2022–2023 rate-hike cycle.

At that time, the upper bound of the benchmark interest rate reached a peak of 5.5%.

The report noted that the market is still underestimating the ultimate terminal rate of the Fed's rate hikes, advising investors to prepare for a rise in 2-year Treasury yields.

Currently, the interest rate swap market expects the Fed to raise rates three more times, bringing the effective federal funds rate to 4.5%–4.75%.

The 2-year Treasury yield also stood at around 4.7% as of September 18.

The BofA team stated in the report, "The Fed does not currently view monetary policy as restrictive and is likely to continue raising rates until financial conditions turn restrictive.

In this case, a clear flattening of the short-to-long-term yield curve will emerge as short-term yields surge while long-term yields do not rise."

The report projected that the 2-year Treasury yield could climb to 5.25%, matching its 2023 peak level.

The report also pointed out that applying the Taylor Rule—a formula that calculates the appropriate policy rate based on how far inflation and economic output deviate from their targets—suggests the federal funds rate should be at the 5.3% level.

"Short-term Treasury yields may continue to rise, but the spillover effect to long-term bonds will be limited," the report said, forecasting that the 10-year Treasury yield will remain around the current 5% level through the end of the year.

Bloomberg reported that the team behind this report analyzes the bond market and provides investment direction to clients, making it a different organization from the economist team that focuses primarily on the Fed.

Aditya Bhave, a U.S. economist at BofA, maintained his previous forecast in a report on September 16 that the Fed will implement two additional rate hikes this year, one each in October and December.

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