Strategists at Bank of America are advising investors to brace for the possibility that the Federal Reserve could push its benchmark interest rate above 5%. The team, which includes Mark Cabana and Meghan Swiber, argues that rate markets are still underestimating the peak level the central bank's current hiking cycle might ultimately reach, and are urging clients to position for a further rise in two-year Treasury yields.

Swap market pricing currently reflects expectations for three additional quarter-point rate increases, which would bring the effective federal funds rate to a range of 4.5%-4.75%. However, Bank of America contends that overnight borrowing costs could revisit the highs of the 2022-2023 tightening campaign, when the federal funds target rate peaked at 5.5%.

The firm projects that the two-year Treasury yield will climb to 5% this year from its recent level of around 4.7% on Friday, a forecast that diverges from the broader market consensus. The team points to Fed Chair Kevin Warsh's remarks on Wednesday, in which he noted that the rate hike had withdrawn "a degree of accommodation," as an indication that officials do not yet view monetary policy as being restrictive on the economy.

In their report, the strategists wrote: "If the Fed does not view policy as restrictive, they may continue hiking until financial conditions become restrictive, which strengthens our confidence in a flatter yield curve." Beyond their revised yield forecast, the bank is also recommending that clients short two-year Treasuries, with a target yield of 5.25%, roughly matching the peak seen in 2023.

Although Warsh carefully avoided making any commitment to future policy actions, he again expressed dissatisfaction with the trajectory of inflation and underscored the Fed's determination to maintain price stability. These strategists, who track the bond market and seek trading opportunities for clients, operate separately from the bank's team of economists focused on the Federal Reserve.

Aditya Bhave, Bank of America's US economist, stated in a report on Wednesday that his team continues to expect two additional rate hikes this year, in October and December, with no policy action anticipated in 2027.

The Bank of America strategists concluded: "Simple analytical frameworks suggest the federal funds rate should be above 5%. While short-end yields could continue to rise, transmission to longer-dated bonds is expected to be limited, with the 10-year Treasury yield forecasted to reach 5% by year-end, near its trading level on Monday."