Bank of America: Keep an Eye on the Japanese Market, It Will Be the "Canary in the Coal Mine" for a Global Decline

The current market consensus is built on the "four no's": the U.S. economy will not experience a hard landing, the Federal Reserve will not raise interest rates, AI spending will not be cut, and the Democratic Party will not sweep the midterm elections.

Written by: Li Jia, Wall Street Insights

The market has almost formed a one-sided bullish consensus, which is precisely the risk signal that Bank of America is most concerned about.

The latest edition of Bank of America's "The Flow Show" fund flow report shows that as of the week ending July 8, global equity funds attracted another $56.6 billion in inflows, with technology stocks likely to set a new historical record for inflows this year; meanwhile, Bank of America's Bull & Bear Indicator remains in the extremely optimistic range of 9.5, with "sell signals" triggered for several consecutive weeks.

Bank of America’s Chief Investment Strategist Michael Hartnett believes that the current market is betting on the "four no's"—the U.S. economy will not experience a hard landing, the Federal Reserve will not raise interest rates, AI capital expenditures will not be cut, and the Democratic Party will not sweep the midterm elections. It is these four consensus points that support the continuous rise of risk assets, but any one of these expectations falling short could become the catalyst for a market downturn.

Among all risk observation indicators, Hartnett specifically names the Japanese market. He believes that Japanese bank stocks remain the "canary" for global risk appetite: if Japanese government bond yields rise rapidly, leading to a weakening of bank stocks, it could indicate that global risk assets are entering an adjustment cycle.

Bull & Bear Indicator Continues to Flash Red: "Everyone is Fully Long"

Bank of America’s Bull & Bear Indicator continues to hold at 9.5 this week, well above the warning line of 8, which triggers a "sell signal." Historical data shows that over the past 24 years, this indicator has issued 17 sell signals, after which the global ACWI index averaged a decline of 2%-3% over the next 2 to 3 months, with a hit rate of about 60%, and in extreme cases, maximum drawdowns reached 15%-20%.

From various sub-indicators, market sentiment is almost entirely in an extremely optimistic state: hedge fund positions are at the 81st percentile; global equity fund flows are at the 88th percentile; bond fund flows are at the 84th percentile; and fund manager positions have reached the 100th percentile. The only indicator still in a neutral position is the breadth of the global stock market.

Meanwhile, Bank of America’s global fund flow trading model has maintained a sell signal for eight consecutive weeks.

Global Funds Continue to Pour into Stocks, Tech Stocks Set to Break Historical Records

Funds continue to chase risk assets. As of the week ending July 8, global equity funds saw a net inflow of $56.6 billion, marking the fourth-largest weekly inflow this year; among them, technology funds attracted $18.8 billion in a single week, and if this pace continues, the net inflow for technology funds in 2026 will reach $183 billion, setting a new historical high.

Regional fund flows also reflect a rebound in risk appetite: U.S. equity funds regained a net inflow of $25.1 billion; Chinese equity funds saw an inflow of $9 billion, the largest since December last year; while European equity funds experienced outflows for the 13th consecutive week. Meanwhile, investment-grade bonds have seen net inflows for 14 consecutive weeks, and bank loan funds recorded the largest single-week inflow since February last year.

Notably, cash has not exited the market. The size of money market funds has risen to $7.9 trillion, setting a new historical high, and still attracting $39.5 billion in inflows that week, indicating that a large amount of capital is chasing risk assets while retaining ample "ammunition" for new allocation opportunities.

Japanese Bank Stocks Become the Most Important Warning Signal in the Global Market

Compared to U.S. tech stocks, Bank of America is more focused on the Japanese market. Hartnett points out that over the past three years, the yield on Japan's 10-year government bonds has risen from about 0.5% to nearly 3%, while Japanese bank stocks have tripled during the same period, becoming one of the strongest sectors globally.

In his view, Japanese bank stocks actually reflect the global liquidity and yield environment. If Japanese government bond yields continue to rise rapidly and begin to suppress bank stock performance, this change could indicate that global risk appetite is starting to reverse and become the earliest "canary" signal for a global stock market adjustment.

The Market's Rise is Supported by the "Four No's"

Hartnett summarizes the current market's optimistic expectations as the "four no's."

First, the U.S. economy will not experience a hard landing, meaning corporate profits still have support, and funds continue to choose to "stay away from bonds and embrace stocks."

Second, the Federal Reserve will not raise interest rates again at least before the midterm elections, and global central banks overall still maintain a loose tendency. So far this year, global central banks have cut rates a total of 34 times, exceeding 21 rate hikes.

Third, AI capital expenditures will not be cut. The market expects that global tech giants will spend about $800 billion on AI capital expenditures in 2026, further rising to about $1 trillion in 2027, which remains the most important support for tech stock valuations.

Fourth, the Democratic Party will not sweep the U.S. midterm elections, so fiscal and tax policies will not undergo drastic changes.

Once these four consensus points break, the market will face reverse trading opportunities.

Hartnett also emphasizes that what is truly worth paying attention to is not what the market currently believes, but which consensus is most likely to be broken.

If the U.S. economy ultimately shows significant cooling, with non-farm employment continuing to weaken, long-term government bonds, defensive consumption, high-dividend stocks, and large tech stocks may outperform the market again.

If the Federal Reserve is forced to raise interest rates again, then the dollar and yield curve flattening trades will become the main beneficiaries. Hartnett points out that currently, the U.S. CPI and unemployment rate are both around 4.2%, a combination that has only occurred a few times in the past century, and almost always accompanied by interest rate hikes and market turmoil.

If AI capital expenditures begin to contract, it will directly impact the current market's core investment logic. At that time, the software sector and large tech platforms may relatively outperform, while the Philadelphia Semiconductor Index (SOX) faces greater valuation pressure. Bank of America believes that narrowing debt financing space, deteriorating cash flow, and continuous layoffs by tech giants could all be signs of cooling AI investment.

Political risks cannot be ignored either. If the Democratic Party ultimately sweeps the midterm elections and the Republican Party loses control of the Senate, the market may re-trade scenarios of limited fiscal expansion, a weaker dollar, and declining U.S. Treasury yields.