Bank of America strategist Hartnett presents a counterintuitive judgment: the most favorable event for the stock market before the end of the year is the Federal Reserve proactively raising interest rates in October — using a single tightening to suppress uncontrolled long-term rates.

Written by: Zhao Ying, Wall Street News

In the past week, global markets have once again been driven by interest rates. The yield on the 10-year U.S. Treasury bond briefly reached 5.36%, and the 30-year yield rose to a high not seen since 2002; the auction pricing yield of the 10-year U.S. Treasury bond was the highest since 2000, but nearly record overseas demand pulled sentiments back. Across the Atlantic, the spread of French government bonds expanded to 140 basis points, returning to the stress range seen during the European debt crisis from 2011 to 2012.

Bank of America strategist Michael Hartnett condensed his core judgment in the latest Flow Show into three words: "The end of the bond bubble." The most counterintuitive conclusion also surfaced: the most favorable event for risk assets before the end of the year is the Federal Reserve raising interest rates in October — using a single proactive tightening to suppress the continued loss of control over long-term yields.

This line of reasoning is not contradictory. The U.S. stock market is still up 13.4% this year, with the S&P 500, Nasdaq, and global technology indices remaining at high levels, but government bonds are down 4.4% this year, lagging behind cash returns by 7.2 percentage points. Stocks have not been defeated by interest rates because U.S. hard data, global earnings expectations, and the capital expenditure expectations of large cloud service providers have not been significantly revised downwards; bonds are making cracks first in weaker areas: Korean brokerage firms, French government bonds, CCC-rated corporate bonds.

The real risk is not just "high rates," but rather that after rates rise, fiscal policy, elections, AI capital expenditures, and capital flows are all forced to be repriced. If the Federal Reserve does not raise rates proactively, long-term yields may continue to climb; if the Democrats sweep both houses in the midterm elections, the political discount rate for stocks will suddenly change; if cash yields remain above 4%, the $8 trillion money market funds may not rush into the stock market.

The first hit on bonds is the part that relies most on cheap money

Hartnett uses South Korea as a sample. In the past 18 months, Korean bond yields have risen by about 200 basis points; Korea's largest retail brokerage, Mirae Asset, which had previously surged to "quadruple stock" status, has dropped 65% since May.

This does not mean that the South Korean stock market bubble has burst. The South Korean stock market is still up 98.9% this year, making it one of the strongest markets globally. It indicates another issue: when funding costs suddenly rise, the first to be hurt are often the segments that rely heavily on financial leverage and trading enthusiasm.

Global central banks are also cooperating with this change. Since 2026, central banks worldwide have raised interest rates 54 times; this is the first time since September 2023 that global central banks have turned back to tightening in net terms.

The differentiation in asset performance further confirms this tearing. Year-to-date performance rankings show oil prices up 58.5%, U.S. stocks up 13.4%, global stocks up 10.6%; cash returns at 2.8%, government bonds down 4.4%, gold down 4.8%, and Bitcoin down 6.7%. The "humiliation" felt by bonds is most pronounced: holding cash has outperformed holding government bonds.

The reason the October rate hike is viewed positively is that not raising rates may allow long-term rates to go out of control

The main reason for the rise in U.S. interest rates can be divided into two parts: growth is still strong and uncertainty is increasing. Supply, commodity, and fiscal concerns also play a role, but they are not the core explanation.

A key change occurred after Jackson Hole. Previously, the market had an anchor: policy was already restrictive, and rates could eventually return to around 3%. Bank of America interest rate strategists point out that once this "anchor line" is cut, yields will continue to rise until data worsens or the market has issues. Their conclusion is not friendly for those waiting for a peak: "We believe that currently neither of these conditions is met. Any dovish suppression from the Federal Reserve on short-term pricing will only shift interest rate pressure to the longer end."

This time, the rise in the 10-year U.S. Treasury bond since late September mainly comes from term premiums, rather than a repricing of the federal funds rate path. This complicates the issue further.

Hence, the seemingly strange judgment arises: the Federal Reserve must either raise rates or face continued steepening of bond yields. The September FOMC minutes showed that 19 officials supported a rate hike, with a majority believing another increase this year would be appropriate. However, the market currently assigns a 17% probability of a hike at the October 28 meeting, and an 81% probability for December 9. Bank of America interest rate strategists believe the market pricing is wrong and have established corresponding trading positions (paying October FOMC OIS). Their statement is concise and direct: "If U.S. data remains strong, the Federal Reserve must make a choice: raise rates or endure steepening of bond yields. If spooked by the steepening of bonds, the Federal Reserve will raise rates."

The bullish logic here is not that "raising rates itself is good for stocks," but rather: if the Federal Reserve uses the October rate hike to prove its willingness to control inflation and term premiums, the market may instead stop worrying about the 10-year yield rushing towards 6%, and thus relieve pressure on stocks.

Fiscal fissures have already emerged, with France being the clearest sample

The other half of the issue of rising interest rates is who will pay the higher interest. Claudio Irigoyen, Bank of America's chief global economist, points out that the interest rate shock is "exposing the unsustainable reality of fiscal policy in developed economies," with the U.S. and France at the forefront, followed closely by Japan and the UK.

The root of the problem lies in what economists call time inconsistency. Over the past 20 years, U.S. debt/GDP has risen by about 60 percentage points, and French debt has risen by about 50 percentage points, most of which occurred during the zero interest rate era. This debt supports permanent spending and permanent tax cuts. Now that financing costs are normalizing, cutting spending or raising taxes lacks political approval. Both countries' debt/GDP is about 120%, with structural deficits exceeding 2.5% of GDP; the overall deficit in the U.S. is about 6% of GDP, while France's is about 5%, with the higher figure for the U.S. mainly due to heavier interest burdens.

France presents the clearest fracture. According to Bloomberg, the spread of French government bonds has returned to 140 basis points, the fastest rate of sovereign spread sell-off in at least 20 years, even quicker than in 2011. The market is showing little patience for French public finances, with several data points at play: since the post-pandemic peak, average debt/GDP in developed economies has fallen by 11 percentage points, while France's has not decreased; French private non-financial debt is 214% of GDP, versus 140% in the U.S.; the median net income of French retirees is nearly on par with that of current workers; France has not achieved a basic budget surplus since 1974.

According to The Wall Street Journal, Paris is considering increasing the issuance of short-term government bonds. Rabobank commented that this is "the latest example of a developed market economy behaving like an emerging market." Barnaby Martin, a Bank of America European credit strategist, anticipates that the French-German spread will oscillate between 100 and 150 basis points; if it quickly approaches the upper range, the likelihood of discussions around short debt issuance, European Central Bank verbal interventions, or even TPI tools will increase.

Just because stocks haven't fallen doesn't mean rate hikes haven't "bitten"

High rates are not without impact; they simply haven't yet affected the most core assets in the market.

U.S. hard data has not shown any obvious retraction, and global future earnings expectations have also not fallen. More crucially, the capital expenditure expectations of large-scale cloud service providers are still on the rise, with market consensus for 2027 continuing to steeply increase. As long as AI capital expenditures continue to support real demand, there are reasons for yields to continue rising. Bank of America strategist Barnaby Martin's conclusion is that the moment U.S. macro data begins to decline is the time when interest rate volatility peaks and the credit market lights up again.

The credit market has already begun to reflect pressure on the edge. In September, the high-yield bond spread widened, with less than 30% explainable by higher refinancing costs or expected losses, while the rest more resembles an interest rate volatility premium. The CCC spread has risen to 1,200 basis points, the highest since 2022.

Within stocks, there are also signs of loosening. The BofA Bull & Bear Indicator fell from 8.8 to 8.1, having been at 9.3 just two weeks ago, still in the "sell" zone. The global breadth ruler shows that a net 50% of global stock indices are in oversold territory, being below both the 50-day and 200-day moving averages; however, a reverse buy signal will only trigger at a net 88%, and unless technology-weighted markets in the U.S. and South Korea quickly reverse, it will be difficult to reach this threshold in the short term.

$8 trillion cash is not a natural buying force

The signals given by capital flow data are quite clear.

As of last Wednesday, cash flowed in by $166.4 billion, the largest since April 2020; bond inflows were $33.8 billion, stock inflows were $12.4 billion, gold inflows were $2 billion, and cryptocurrency outflows were $600 million. The $118 billion cash outflow from the previous week due to quarter-end factors not only fully returned but also experienced excess inflow.

In detail, Treasury bonds saw inflows of $16.2 billion, the largest since April 2025; investment-grade bonds had inflows of $10.3 billion; bank loans saw inflows of $2.4 billion, the largest since February 2025, with floating rate products becoming tools for hedging against rate hikes. Tech stocks still had an inflow of $3.5 billion, while financial stocks saw an outflow of $3 billion, the largest since March 2023.

The size of money market funds has now reached about $8 trillion, while it was $5 trillion in 2023. At an interest rate of 4.2% for T-bills, this amount generates roughly $330 billion in interest income annually.

Hartnett's cash perspective is even more direct: "Without rate cuts, cash will not decrease." Historically, large-scale cash inflows into the stock market typically occur after significant monetary easing, such as in the QE of 2009, QE4 in 2020, or during a continuous interest rate cut cycle by the Federal Reserve. The current environment does not meet this condition.

The midterm elections create an uncomfortable probability distribution for the market

The U.S. midterm elections on November 3 may be the event most likely to trigger a 10% level of volatility in the stock market in the coming months.

Polymarket currently gives the Democrats a 64% probability of sweeping both houses, up from 49% in September; the probability of the Republicans keeping the Senate while the Democrats take the House is 28%; and the chance of a Republican sweep is just 9%. Trump's approval rating is at 38%, with economic issue support at 34% and inflation issue support at 27%.

The market's most uncomfortable aspect is that the currently leading probability outcome precisely corresponds to the path that is most averse to risk.

In the scenario where the Democrats sweep both houses, stocks could drop more than 10%, the dollar and bond yields could retreat, and international stocks could outperform U.S. stocks; Europe might outperform Asia. An upward trend in tax policy and regulation could negatively impact EPS. More importantly, the political capital for the Trump administration promoting resource monopolies and corporate policy coordination will decrease.

If the Republicans uphold the Senate while the Democrats secure the House, it corresponds to the risk appetite path of "divided government = goldilocks," where stocks might rise more than 5%. A Republican sweep would present the largest upside surprise, with stocks potentially rising more than 10%, and AI trading continuing to approach bubble conditions by 2027.

The key observation state may be Texas. The incumbent Republican governor Greg Abbott leads Democratic challenger Hinojosa by only 48% to 46% in polls. Texas is also the focal state for AI data center approvals and power pressures, and the conflict between "affordability" and AI capital expenditure will be repriced at the ballot box.

Beyond the U.S., the rightward political trend continues

While the political risk in the U.S. leans negative, there is another logical line overseas: the rightward trade.

Brazil's Bolsonaro won the first round, with the second round of voting on October 25. Out of 20 countries in Latin America, 11, accounting for about 420 million people, are under right-wing leadership; before the previous election, this number was only 7 countries, representing about 60 million people. The market reacted directly: Brazil's stock market hit a record high, and the 10-year yield plummeted by 124 basis points in a single day.

The MSCI Latin America index is still 35% lower than its historical peak, which is why Latin America is now assimilating into the global rotation bull market sequence: the first half of 2025 is Europe, the second half of 2025 to the first half of 2026 is Japan and emerging Asia, and now it is Latin America's turn with a broader emerging market.

Europe has similar political variables. Italy and Germany have shown signs of a rightward shift, while polls for the 2027 French presidential election show Le Pen in the lead. Spanish Prime Minister Sánchez has announced early elections, set for November 29, with polls indicating a lead for the center-right — Hartnett qualifies this as "an underrated positive event for European bonds."

Next, focus on price levels; several key points are more important than the macro narrative

In this framework, short-term positions lean toward risk reduction before the midterm elections. This judgment is supported by three clues: global central banks are re-tightening in net terms, financial conditions are tightening, and early signals of credit events are still emerging, including AUD/JPY exchange rates, risk parity strategies, and credit default swaps of tech companies like Oracle and SoftBank.

Tech stocks are not suitable for continued upward chasing, as investors are already heavily invested; MAGS may still outperform SOX, and Chinese tech stocks have counter-cyclical appeal. On the bond side, it is better to pre-arrange positions for peak yield trades: 30-year U.S. Treasuries, small-cap stocks, REITs, and Hong Kong real estate. The overall direction maintains holdings in gold, commodities, and emerging markets.

Several price levels are more operationally significant than macro slogans: 6% for the 10-year U.S. Treasury bond is a key area of buying interest; 150 basis points for the French-German spread indicates an increasing probability of policy support; a net 88% oversold on the global breadth rule is a stronger sign for reverse buying; a Bull & Bear Indicator dropping below 8—closer to the risk relief range than the current 8.1; and the 30-year Treasury auction yield has reached 5.618%, which also serves as a practical tool for arranging long bonds.

The calendar is also dense: October 25 is Brazil's second round vote, October 28 is the FOMC, November 3 is the U.S. midterm elections, November 18 is the Shenzhen APEC, November 29 is the Spanish election, December 9 is the FOMC, and December 14 is the Miami G20.

Hartnett concludes with a statement: "Most investors are waiting for the 10-year yield to reach 6% before buying Treasuries; we have preemptively made a small arrangement on 'peak yield' trades." If the Federal Reserve raises rates in October and suppresses the long end, risk assets may actually breathe a sigh of relief; if the midterm elections result in a Democratic sweep, U.S. stocks will need revaluation; if yields continue to rise while data does not retract, the logic of the end of the bond bubble will continue to take effect in the most vulnerable areas.