BofA Warning: Fed’s Dovish Rate Cuts May End the “Santa Claus Rally”

Bank of America strategist Michael Hartnett has issued a warning that if the Federal Reserve sends excessively dovish signals at its upcoming policy meeting, it could jeopardize the widely anticipated year-end “Santa Claus Rally.” Although the probability of a rate cut has risen to 90%, Hartnett argues that a dovish stance may signal the economy is slowing more than expected, triggering a selloff in long-term Treasuries and becoming a key risk to further equity market gains. The S&P 500 is currently just shy of its all-time high, and the market is facing a delicate balancing act between policy expectations and economic reality.

Key Warning: Why Dovish Signals Could Become Market Risks

In his latest report, BofA Chief Investment Strategist Michael Hartnett offers a counterintuitive perspective: a dovish Fed rate cut may not boost stocks but could instead spark the end of the “Santa Claus Rally.” The report notes that the S&P 500 is approaching its October all-time high as markets are immersed in an ideal scenario of “rate cuts, falling inflation, and economic resilience.” However, if the Fed’s policy statement comes off as overly cautious or pessimistic, it may be interpreted as a sign that the economic slowdown is worse than previously thought, thereby undermining investor confidence.

Hartnett specifically emphasizes: “The only thing that can stop the Santa Claus Rally is a dovish Fed rate cut triggering a selloff in long-term Treasuries.” The critical logic here is that an excessively dovish policy signal could heighten market fears of recession, prompting investors to sell long-dated bonds to avoid interest rate risk, pushing up long-term yields. High-valuation sectors like tech are highly sensitive to risk-free rates, so rising Treasury yields would directly pressure equity valuations, offsetting the liquidity benefits of a rate cut.

Market Background and Historical Patterns of the “Santa Claus Rally”

The “Santa Claus Rally” refers to the seasonal rise in US stocks during the last five trading days of the year and the first two of the following year. Historically, since 1950, the S&P 500 has risen about 78%-80% of the time during this period, with an average gain of 1.3%-1.64%. Multiple factors usually drive this phenomenon: lower volatility as institutional traders go on holiday, seasonally optimistic investor sentiment, year-end bonus reinvestments, and the self-fulfilling prophecy effect.

Currently, technical conditions are in place for a rally. As of December 5, the S&P 500 is only about 0.5% below its October all-time high, with the Nasdaq and Dow also in high territory. Investors have seen net inflows into equity funds for six consecutive weeks, with $186 billion flowing in over the past nine weeks. In addition, CME data shows the probability of a 25bp rate cut in December has climbed to 87%-90%, supporting market expectations for policy easing.

Economic Fundamentals: The Twin Challenges of Weak Data and Sticky Inflation

Despite the market’s optimism, US economic data shows significant divergence. The labor market is notably cooling: November’s ADP private payrolls unexpectedly shrank by 32,000, the fourth negative print in six months; the September unemployment rate rose to 4.4%, its highest since October 2021. The manufacturing PMI has been below the boom-bust line for nine straight months, and November’s ISM manufacturing index was just 48.2.

Meanwhile, inflation remains stubbornly sticky. The core PCE price index for September—delayed due to a partial federal government shutdown—is expected to rise 2.8% year-over-year, marking 55 consecutive months above the Fed's 2% target. This “weak jobs + high inflation” stagflation concern is the root of the Fed’s policy dilemma. If the central bank overemphasizes downside risks while cutting rates, it may reinforce stagflation fears and trigger simultaneous declines in stocks and bonds.

Long-Term Treasury Selloff: Transmission Mechanism and Market Impact

Hartnett’s warning focuses on the transmission path of “dovish rate cut → long-term Treasury selloff → yield spike → stock market under pressure.” Normally, rate cut expectations drive bond prices up and yields down. But if recession fears intensify, investors may suddenly dump long-dated assets, steepening the yield curve.

This risk is not unfounded. Japanese long-term government bond yields have recently climbed, with the 10-year breaking the 2% key level and the 30-year at 3.43%, sparking concerns about global liquidity tightening. If the US sees a similar trend, high-growth sectors like tech will be hardest hit. Notably, tech now makes up over 30% of the S&P 500 by weight, so any upward rate pressure will significantly affect the index.

Policy Uncertainty: New Fed Chair Prospects and Government Intervention Odds

The report also points to two key risk variables: Fed leadership changes and potential government policy intervention. The Trump administration has hinted that National Economic Council Director Kevin Hassett could be the next Fed chair, and his dovish stance is seen by markets as likely to accelerate rate cuts. However, Hartnett’s team believes the government may intervene to curb inflation and rising unemployment, and such unpredictable intervention would add to market volatility.

Additionally, delayed releases of nonfarm payrolls and CPI data until late December will be crucial to watch. Significantly weaker-than-expected data could fuel recession fears; stronger data could reduce the need for rate cuts. Either way, market volatility is set to rise sharply.

Investment Strategy: Shift Toward Mid-Caps and Cyclical Sectors

In the face of uncertainty, Hartnett suggests investors adjust their allocation strategies. His team recommends focusing on “low-valuation” mid-cap stocks in 2026, believing these assets offer a higher margin of safety in uncertain times. He also recommends allocating to cyclical sectors such as homebuilders, retailers, REITs, and transportation, which are expected to deliver the best relative returns.

This aligns with BofA’s long-held view that international equities are more attractive than US stocks. Data shows that since 2025, the MSCI World Index (excluding the US) has outperformed the S&P 500, reflecting a decline in the relative appeal of the US market. Investors can diversify risk by reducing US equity exposure and increasing allocations to emerging markets.

Market Outlook: Short-Term Euphoria, Long-Term Concerns

The current market displays classic “front running expectations.” Investors have nearly fully priced in a December rate cut, and year-end FOMO has pushed US equities near record highs. However, strong data could still alter the Fed’s decision. Brokerage Macquarie notes that if inflation data surprises to the upside in the next two weeks, some policymakers may shift to a “wait-and-see” stance.

Bob Schwartz, senior economist at Oxford Economics, notes that Americans are pessimistic about the labor market, and the Beige Book shows companies are reluctant to hire and households are cutting spending. These leading indicators suggest that even if a “Santa Claus Rally” occurs, its sustainability is questionable. History shows that if the S&P 500 falls during this period, the following year’s performance is usually poor, with an accuracy rate of 80%.

Conclusion: Beware the Risk of Policy Signals Diverging from Fundamentals

BofA’s warning reveals a key investment logic: at high valuations, the market’s framework for interpreting policy signals reverses—good news is priced in, and dovish signals could be read as economic warnings. Investors should closely monitor the wording of the December 18 Fed decision, changes to the dot plot, and signals from Powell’s press conference.

Defensive strategies are advised: maintain core positions while increasing allocations to mid-caps and value stocks; use options strategies to hedge downside risk; and monitor market reactions after delayed economic data releases. In an environment of both liquidity-driven exuberance and underlying market concerns, risk control is more important than chasing returns. If the Fed manages a “hawkish rate cut” (i.e., cuts rates while emphasizing economic resilience), the Santa Claus Rally may continue; but if a dovish stance triggers a long-term Treasury selloff, a market correction will be inevitable.

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