UBS told a "ghost story": The Federal Reserve may raise interest rates to 6.5% next year

UBS analysts Jonathan Pingle and Bhanu Baweja recently stated that although UBS's baseline scenario predicts two interest rate cuts by the Federal Reserve this year, they now believe that the possibility of inflation not falling to the Fed's target is increasing. The strong U.S. economy and stubborn inflation are raising the likelihood of the Fed raising interest rates instead of cutting them, with the possibility of the U.S. raising rates to 6.5% next year.

Specifically, if the U.S. economic expansion remains resilient and inflation remains stagnant at 2.5% or higher, then the risk of the Fed resuming rate hikes early next year will be high, with the federal funds rate possibly reaching 6.5% by mid-next year.

UBS analysts stated that investors are starting to worry that the U.S. economy may be overheating. If the Fed shifts back to rate hikes, UBS predicts that it will trigger significant selling in the U.S. bond market and stock market. In the so-called "no soft landing scenario," more rate hikes will lead to a sharp flattening of the U.S. Treasury yield curve, a significant increase in benchmark bond yields, and a potential 10%-15% decline in the stock market. In a high inflation environment, U.S. government bonds are expected to be sold off, credit spreads will widen, and valuation multiples will decrease significantly.

With recent surprising resilience shown in U.S. data, the market has reduced bets on the extent of Fed policy easing. After stronger-than-expected U.S. retail sales data was released on Monday, traders no longer believe that there will be a 100% chance of rate cuts before November this year.

UBS's report highlights that mainstream Wall Street banks are beginning to accept the possibility that the Fed's rate hike cycle is not yet over. Last week, following the release of higher-than-expected U.S. inflation data, major Wall Street banks have lowered their expectations for rate cuts. Goldman Sachs expects the Fed to cut rates twice this year, while Barclays Bank expects only one rate cut. Bank of America and Deutsche Bank both agree that the Fed will only cut rates once in December this year. Deutsche Bank further pointed out that if future inflation data continues to disappoint, or if election results lead to fiscal policies that exacerbate inflation, the Fed will not cut rates this year or in 2025