A new report from Bank of America reveals a chain reaction: a slowdown in the US stock market rally could directly expose a structural weakness in bond market demand. Over the past five years, a mysterious force supporting the markets has been quietly receding.
Bank of America indicates that weakening US equities could pose a significant risk to the bond market. Strategists noted that if rebalancing fund flows diminish, a crucial source of demand for bonds would shrink.
This week's markets could see increased volatility due to employment growth figures, CPI data, and a large number of corporate earnings releases.
US stocks have performed strongly in recent years. However, as the Dow Jones Industrial Average surpassed the 50,000-point milestone, upward momentum may begin to fade. In response, a team of interest rate strategists at Bank of America, led by Eleanor Xiao, published an insightful research report. They found that the stock market rally since 2021 has generated substantial fund inflows into the bond market, driven by investors rebalancing their portfolios towards the so-called "60/40 balanced allocation" (60% stocks and 40% bonds).
According to their calculations, for every $10 trillion increase in assets, portfolios would typically sell approximately $37 billion worth of stocks monthly and purchase an equivalent amount of fixed-income assets, including US Treasuries, corporate bonds, and mortgage-backed securities.
This sounds like a significant amount, and indeed it is. Their estimates suggest that since 2021, these flows have accounted for 14% of US Treasury supply and 22% of investment-grade bond supply.
However, these fund flows are likely to slow down. Bank of America strategists stated, "Equity returns are projected to moderate significantly by 2026, with our US equity strategy team forecasting just a 4.5% gain for the S&P 500. Concurrently, our economics team expects the Federal Reserve to implement only two rate cuts this year. These conditions collectively point to smaller and weaker rebalancing flows into duration assets. Consequently, one of the most reliable drivers of bond market demand over the past five years may diminish."
They added that slowing equity returns, increased capital expenditure, policy uncertainty, and narrowing market breadth all suggest that rebalancing momentum heading into 2026 will become more subdued and lack clear direction.
Ironically, the drying up of these flows could ultimately enhance the role of bonds within a balanced portfolio. This is because rebalancing flows have recently increased the correlation between stocks and bonds.
Bank of America pointed out, "The stalling of the rebalancing engine might allow the stock-bond correlation to revert to its traditional dynamic, thereby enhancing the diversification benefits and safe-haven hedging capabilities of long-duration positions within a portfolio."