Bank of America Hartnett: "American Denial" begins, go long on short-term bonds, short U.S. stocks, until the Federal Reserve "panics"

The era of American exceptionalism is coming to an end, has "American denialism" already begun?

Bank of America's Chief Investment Officer Michael Hartnett's latest report points out that "the era of the United States buying goods from the rest of the world — and the rest of the world buying U.S. Treasury bonds" is over, and U.S. assets are facing a "buyer strike" from foreign investors. Notably, the U.S. Treasury market experienced a “buyer strike” in 2023, which was ultimately alleviated through a joint statement from the Treasury and the Federal Reserve.

Hartnett states that considering foreign capital holds 33% ($8.5 trillion) of U.S. Treasury bonds, 27% ($4.4 trillion) of U.S. corporate bonds, and 18% ($16.5 trillion) of U.S. stocks, this shift means for investors that the dollar will enter a bear market, the U.S. Treasury yield curve will steepen, and the S&P 500's valuation "floor" of 20 times has now become the new "ceiling."

Hartnett reminds readers to pay attention to the "3P rule": Extreme pessimism in positioning + extreme pessimism in profit expectations = policy panic, which often marks significant market bottoms.

"Long 2s, Short Spoos" — Until the Federal Reserve takes action

Hartnett emphasizes that last week's major market dynamics were "U.S. yields rising, stock markets falling, and the dollar weakening," which is driving global asset liquidation and may force policymakers to take action.

He suggests "selling on rallies," meaning going long on 2-year Treasury bonds and shorting the S&P until:

1. The Federal Reserve significantly cuts interest rates to break the liquidation cycle
2. Trump suspends tariff policies to reverse the global economic downturn

Notably, Hartnett still believes that if policy panic leads to a brief recession, the S&P 500 index at 4800 is an appropriate level to buy risk assets.

"3P rule" guides market bottom judgment

Hartnett reminds readers to pay attention to the "3P rule": Extreme pessimism in positioning + extreme pessimism in profit expectations = policy panic, which often marks significant market bottoms.

In terms of positioning, Hartnett points out that investor sentiment is extremely pessimistic (which is why risk assets may rebound), but data shows that the pessimism in investor sentiment far exceeds the actual pessimism in positioning. Bank of America's "Bull-Bear Indicator" is currently at 4.8 (not below 2), and stock fund outflows are far from approaching 1-1.5% of assets under management (currently at 0) This is why Hartnett believes investors will reduce their allocation to risk assets during a rebound.

On earnings, Hartnett believes any recession in the U.S. could be brief or mild, with the S&P 500 pricing this in around 4,800 points (EPS of $250 + policy responses keeping the P/E ratio at 19-20 times). However, many believe EPS will be broadly revised down by 10-15% to $230, and capital outflows from the U.S. mean the P/E ratio could fall to 17-18 times, potentially bringing the S&P down to 4,000 points.

On policy, interest rate cuts by the Federal Reserve and easing trade policies will be beneficial for risk assets, preventing a recession. Hartnett states, "The good news" is that four polls since April 2 have shown Trump's approval rating dropping from 48-50% to 45%, thus both the bond market and the voter base are now pressuring for a reversal of U.S. trade policy