Is the Federal Reserve repeating the 2022-style rate hikes? Bank of America warns: Rates may return above 5%, suggests shorting two-year U.S. Treasuries.

According to Jinse Finance APP, Bank of America strategists believe that now is the time for investors to prepare for the risk that the Federal Reserve will raise its benchmark interest rate above 5%. The team, led by Mark Cabana and Meghan Swiber, stated that rate markets are still underestimating the end point of this rate hike cycle that began this week, and urged clients to position for a further rise in the two-year U.S. Treasury yield.

Currently, rate swaps are implying three more 25 basis point hikes, which would push the effective federal funds rate into the 4.5%–4.75% range; however, Bank of America believes the overnight borrowing cost could return to the peak of the 2022 to 2023 rate hike cycle—when the target rate reached as high as 5.5%.

They predict the two-year U.S. Treasury yield will rise to 5% this year, while on Friday it stood at around 4.7%, a forecast that runs counter to market consensus. The Bank of America team said that Chair Kevin Walsh’s comment on Wednesday's rate hike, describing it as removing a “dose of accommodation,” indicates that officials do not yet see monetary policy as restraining the U.S. economy.

“A Federal Reserve that doesn’t view policy as restrictive could continue raising rates until financial conditions genuinely become restrictive, which strengthens our belief in a flattening yield curve,” the strategists wrote in their report. In addition to their latest forecast, they also suggested clients short two-year U.S. Treasuries with a target yield of 5.25%—approximately the high of 2023.

Although Walsh cautiously made no commitments regarding subsequent actions, he reiterated his dissatisfaction with the inflation trajectory and emphasized the Federal Reserve’s commitment to price stability. In recent trading sessions, the U.S. Treasury yield curve has flattened, with short-end yields rising faster than long-end yields, as traders increase bets on further Federal Reserve rate hikes.

This group of strategists covers the bond market and identifies trading opportunities for clients; they are a separate team from Bank of America economists who focus on central bank research. In a report released Wednesday, Bank of America U.S. economist Aditya Bhave stated that his team sticks to their assessment of two more rate hikes this year—in October and December—and expects no policy moves in 2027.

Bank of America strategists also pointed to the latest Summary of Economic Projections (SEP) from the Federal Reserve, noting that officials see inflation risks as much greater than unemployment risks. They also cited a calculation based on the Taylor rule—a widely used formula that generates the recommended policy rate based on the degree inflation and economic output deviate from target levels—which suggests the federal funds rate should be around 5.3%.

“Simple frameworks indicate the federal funds rate should be above 5%,” they said. “While front-end yields can continue to rise, we expect the transmission to longer maturities to be more limited.” They expect the 10-year U.S. Treasury yield to finish the year at 5%, close to the trading level seen on Monday.