The Federal Reserve will continue to raise interest rates 'until the labor market cracks,' Bank of America says

• The Federal Reserve will want to see the US labor market shedding jobs before it stops raising interest rates, Bank of America said Thursday.
• To fight inflation, policymakers are hiking rates "with the expressed purpose of rebalancing the labor market," the investment bank said.

The Federal Reserve in its campaign to cool inflation will want to see the US labor market shedding jobs before it stops raising interest rates, Bank of America said Thursday.

The investment bank's view was expressed in a note by rates strategist Meghan Swiber before the Labor Department on Friday publishes its September nonfarm payrolls report. Economists polled by Econoday were, on average, looking for the addition of 250,000 jobs and a steady unemployment rate of 3.7%.

Recent tightening in financial conditions and last week's bond market intervention by the Bank of England prompted markets to temper expectations about the Fed's terminal rate, or the peak level of the fed funds rate before the US central bank begins to cut it down. The Fed last month indicated a terminal rate of 4.6%, while the current range sits at 3% to 3.25% after five rate hikes this year.

"Clients have asked if we foresee an imminent shift in stance from the Fed … We think these concerns are misplaced and that the Fed's job is still far from over," said Swiber. "The Fed will keep hiking until the labor market cracks. To us this means the Fed is confident that payrolls growth has reached an inflection point and unemployment is on an upward trajectory."

A change in the month-over-month reading to negative from positive would constitute a payrolls inflection point. The Fed usually stops hiking rates before payrolls prints are negative, the strategist said. "We think that this cycle could be different since the Fed is hiking with the expressed purpose of rebalancing the labor market (similar to what was observed in the 80s)."

The Fed's latest Summary of Economic Projections indicated the Fed sees the unemployment rate increasing to 4.4% by the end of 2023.

"While the Fed is likely to slow the pace of hikes once it hits 4% in November, we think the data is unlikely to warrant a pause until those negative payrolls prints are almost in hand. In our view this is not until March of next year," said Swiber.

BofA's economists expect a terminal rate of 4.75% to 5.00%, which was currently about 30 basis points above consensus expectations. The gap stems from uncertainty around whether the Fed will raise rates by 75 basis points again in November and from questions over how long the hiking cycle will continue.

She said further upside surprises in labor data will likely allow the market to keep pushing the pricing of the terminal rate higher. "[We] continue to recommend clients stay short front-end US Treasurys." The front end of the Treasury curve is sensitive to surprises in payrolls reports during rate-hiking cycles, she noted.

The 2-year yield was up 6 basis points to 4.21% on Thursday, and this year it jumped above 4% for the first time since 2007. US equities this year have dropped into a bear market as the Fed embarked on an aggressive path of rate hikes to pull down inflation, which was 8.3% in August.