Watch out for the Pain Trade and Vain Trade as investors flood to bonds - BofA

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The short-term equity risk premium is back to levels not seen since before the Financial Crisis and cash is piling into bonds, BofA Securities says.

The U.S. 2-year Treasury yield is now 280 basis points higher than the S&P 500 dividend yield (SDY), the widest spread since 2007 and investors are "flooding to short-duration bonds (NASDAQ:SHY)," strategist Michael Hartnett wrote in the weekly Flow Show note.

The risk to equities is that this continues via rotation from stocks (NYSEARCA:SPY) (QQQ) (DIA) (IWM) (IWB)," Hartnett said.

In addition, "US commercial bank deposits (are) down record $360bn since April '22 peak ($18.1tn)," with rotation to T-bills and other debt a big factor," Hartnett added.

But it's important to note that the "last great disorderly drop in bank deposits was 1994 (Orange County, Mexico peso credit events)," he said.

A bullish stock environment could be found, though, if there is a high in the U.S. dollar (DXY) (USDOLLAR) (UUP) that indicates a shift from quantitative tightening to quantitative tinkering. That's where central banks become "petrified of market consequences of liquidity withdrawal" like those seen in the U.K., Hartnett said.

The 3 trades

Hartnett outlined three trade scenarios:

• Main Trade - Long T-bills and short-dated Treasuries on big yield, hedging for a recession and credit event.
• Pain Trade - New highs in spreads and a flush in the S&P (SP500) to the pre-COVID high of 3,333 as the bear rally in risk becomes "too consensus."
• Vain Trade - Long U.S. dollar and Big Tech in the U.S, Big Luxury (LUXE) in Europe.

"We are bearish despite ubiquitous bear sentiment; inflation shock, rates shock ongoing + recession shock & credit shock starting; new highs in yields, spreads, low in stocks coming."

Could the 10-year yield topping 4.5% bring about the sought-after washout in sentiment?