Bank of America Tells Bond Clients to Position for a Policy Rate Above 5 Percent
Rates strategists at Bank of America have told clients that the interest rate market is underestimating where the American tightening cycle ends, and that investors should prepare for the possibility of a policy rate above 5 percent. The call, reported on 18 September, came 2 days after the Federal Open Market Committee raised its target range by a quarter point to 3.75 to 4 percent on a unanimous vote of 12 to nothing.
The team, which includes Mark Cabana and Meghan Swiber, argues that a central bank which does not regard its own policy as restrictive will keep raising rates until financial conditions become restrictive, and that this points to a flatter yield curve. They took their cue from Chairman Kevin Warsh, whose description of the September increase as removing a “dose of accommodation” they read as a sign that officials do not yet see policy as holding the economy back.
| Rate or yield | Level | Date |
|---|---|---|
| Federal funds target range | 3.75 to 4.00% | 16 September 2026 |
| Peak of the 2022 to 2023 cycle | 5.25 to 5.50% | 27 July 2023 |
| Two year Treasury yield | 4.76% | 18 September 2026 |
| Ten year Treasury yield | 5.01% | 18 September 2026 |
Policy rate from the central bank’s own record of open market operations. Yields are official daily par yields.
The trade behind the call
Swaps currently imply 3 further quarter point increases, which would carry the effective funds rate into a range of 4.5 to 4.75 percent. The strategists think the ceiling is higher than that and see scope for overnight borrowing costs to revisit the highs of the 2022 to 2023 cycle, when the target range reached 5.5 percent. They wrote that simple frameworks suggest the funds rate should be greater than 5 percent, and pointed to the central bank’s latest projections, which show officials placing far more weight on upside risk to inflation than to unemployment, and to a version of the Taylor rule implying a policy rate near 5.3 percent.
The expression of the view is in short dated paper. The team forecasts a two year Treasury yield of 5 percent by the end of the year, against about 4.7 percent late last week, and is recommending clients sell two year Treasuries short with a yield target of 5.25 percent, close to the 2023 peak. They expect much less of this to pass through to longer maturities, seeing the ten year finishing the year around 5 percent, roughly where it has been trading.
The house is not of one mind
The strategists cover the bond market and look for trades. The bank’s economists are a separate group, and their published call is narrower: 2 more increases this year, in October and December, and no policy move at all in 2027. Both views sit under the same roof, and the gap between them is a fair measure of how open the question is.
The market has already begun moving the way the strategists describe. On our calculation the two year Treasury yield has risen 37 basis points since 1 September, from 4.39 percent to 4.76 percent, while the ten year has risen 22 basis points, from 4.79 percent to 5.01 percent. That is a curve flattening from the front end, which is what a market pricing more tightening and less growth tends to produce.
Why it matters: For the Gulf this is not an abstract American argument. Most Gulf currencies are pegged to the dollar, while Kuwait manages the dinar against a weighted currency basket, so the cost of money in Washington transmits strongly into regional funding conditions without doing so identically everywhere, and a terminal rate above 5 percent rather than below 4.75 percent is a materially different borrowing environment for regional sovereigns, banks and project finance. On our reading the more useful signal is not the 5 percent headline but the flattening itself, because a front end that keeps rising while the long end does not is the market saying it expects tightening to bite.
Outlook: The Committee meets again in October and in December. The bank’s own economists expect an increase at both. Whether the strategists are right depends on whether financial conditions tighten enough to stop the cycle before the policy rate reaches 5 percent.
Sources: Bloomberg, Federal Reserve, United States Department of the Treasury.
