Is the Fed repeating its 2022-style rate hikes? Bank of America warns: predicts rates returning above 5%, recommends shorting two-year Treasuries.

Bank of America strategists believe it is time for investors to prepare for the risk that the Federal Reserve will raise its benchmark rate above 5%. The team, led by Mark Cabana and Meghan Swiber, said the rates market is still underestimating the terminal level of the hiking cycle that began this week, and urged clients to position for further increases in two-year Treasury yields. Rate swaps currently imply three more 25 basis point hikes, which would push the effective federal funds rate into the 4.5%-4.75% range; Bank of America believes overnight borrowing costs could return to the highs of the 2022-2023 hiking cyclewhen the target rate peaked at 5.5%. They forecast the two-year Treasury yield will rise to 5% this year, versus about 4.7% on Friday, a prediction that runs counter to market consensus. The Bank of America team said Chair Kevin Warsh's remark that Wednesday's hike removed "a dose of accommodation" indicates officials do not yet believe monetary policy is weighing on the U.S. economy. "A Fed that does not believe policy is restrictive may keep hiking until financial conditions are truly restrictive, reinforcing our conviction in a flattening yield curve," the strategists wrote in a report. In addition to their latest forecast, they recommended clients short two-year Treasuries with a target yield of 5.25%roughly the 2023 high. Although Warsh was careful not to commit to any follow-up action, he reiterated dissatisfaction with the inflation trajectory and emphasized the Fed's commitment to price stability. In recent sessions, the Treasury yield curve has flattened, with short-end yields rising faster than long-end yields, as traders increase bets on further Fed hikes. This group of strategists covers the bond market and identifies trading opportunities for clients, and is a different team from Bank of America's economists focused on central bank research. In a report published Wednesday, Bank of America U.S. economist Aditya Bhave said his team stands by its call for two more hikes this year, in October and December, and expects no policy action in 2027. Bank of America strategists also pointed to the Fed's latest Summary of Economic Projections (SEP)officials see upside risks to inflation as far greater than unemployment risks. They also cited one measure of the Taylor rulea widely used formula that generates a recommended policy rate based on how far inflation and economic output deviate from target levelswhich suggests the federal funds rate should be around 5.3%. "Simple frameworks suggest the fed funds rate should be above 5%," they said. "While front-end yields can continue to rise, we expect more limited transmission to longer maturities." They expect the 10-year Treasury yield to end the year at 5%, close to Monday's trading level.