BofA Warns of Warsh’s Fed Raising Rates Above 5% in 2022 Redux

(Bloomberg) -- It's time for investors to prepare for the risk that the Federal Reserve raises its benchmark rate above 5%, according to Bank of America Corp. strategists.

The interest-rate market is still underestimating the endpoint of a Fed hiking cycle that started this week, a team including Mark Cabana and Meghan Swiber said, urging clients to position for higher two-year Treasury yields. Swaps imply three more quarter-point hikes, which would take the effective federal funds rate into a 4.5% to 4.75% range, whereas BofA sees the potential for overnight borrowing costs to revisit the highs from the 2022 to 2023 hiking cycle, when the target rate reached as much as 5.5%.

Their view that two-year yields will rise to 5% this year, from around 4.7% on Friday, bucks consensus. The BofA team said comments from Chairman Kevin Warsh that Wednesday's rate hike removed a "dose of accommodation" suggest officials don't yet view monetary policy as stymieing the US economy.

"A Fed that does not view policy as restrictive is likely to keep hiking until financial conditions become restrictive, strengthening our conviction in a flatter yield curve," the strategists wrote in a note.

While Warsh was careful not to commit to any future move, he reaffirmed his dissatisfaction with inflation's trajectory and drove home the central bank's commitment to price stability. The US yield curve has flattened in recent sessions, with shorter-maturity yields rising faster than those on longer bonds, as traders added to bets for further Fed hikes.

The strategists, who are responsible for covering the bond market and identifying trade opportunities for clients, are a separate group from BofA's economists, who focus on the central bank. In a note published Wednesday, BofA's US economist Aditya Bhave said his team is sticking with their call for two more hikes this year in October and December, with no policy action expected in 2027.

BofA's strategists pointed to the Fed's latest Summary of Economic Projections, which showed officials see much greater upside risk to inflation than to unemployment. They also cited a measure of the Taylor rule — a widely used formula that generates a suggested policy rate based on how much inflation and economic output are deviating from target levels — as implying the Fed funds rate should be around 5.3%.