Key Highlights

• Rebalancing led by fading risk-positive gains in May
• Incremental FX hedging demand likely strong in high-beta markets
• GBP and ZAR face strongest selling pressure

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Hedging of U.S. exposures clear in May and this will support month-end recovery flow

EXHIBIT #1: MONTHLY SCORED FLOW, AGGREGATE AND CROSS-BORDER (WHERE APPLICABLE)

_Source: BNY

Our take

The main strategy heading into the end of May can be characterized simply as “the reversal of the reversal.” Sentiment improved markedly throughout the month due to détente on trade between the U.S. and multiple partners. Risks have not gone away but we believe that sufficient hedging has now taken place through dollar sales accompanying recovery flows into U.S. assets. However, based on both aggregate and cross-border realized flow figures, we find that the dollar was still the worst performer (on a cross-border basis), indicating that it was also being used to fund additional risk exposures elsewhere. Looking at the best-bought names on both an aggregate and a cross-border basis, GBP, EUR and CNY led the way. These could be considered “alternatives” to the dollar in a reserve management sense, but we believe that flows were more active in reflecting gains in underlying asset exposures. As a result, these names may struggle amid month-end rebalancing, to the dollar’s benefit.

Forward Look

Based on our rebalancing methodology, offsetting realized FX flows tend to generate the bulk of rebalancing needs and this will give the dollar a lift. SEK has also struggled due to policy differentials and may find some additional support. However, high-beta markets such as Sweden also saw strong underlying equity-related inflows (see below), which would reduce FX recovery needs. The most exposed currencies are those whose home markets recovered well but also saw realized inflows due to additional hedging on the dollar side. Our analysis indicates that ZAR and CAD will face the greatest rebalancing pressure due to rebalancing of both equity and fixed income portfolios.

GBP, ZAR and CAD equity-related sales could open up value for commodity and materials-based flow

EXHIBIT #2: MONTH-END EQUITY REBALANCING SCORES, G10 + CORE EM

_Source: BNY

Our take

Thirteen out of the 15 markets we track for rebalancing purposes had positive marginal returns in May, and even among the underperformers the outflows were relatively light. The leading performers were in EM: Mexico, South Africa and India. These are also markets which have faced significant stress from trade-related developments and, given prior under-positioning, recovery flow was unsurprisingly strong. Coupled with a general recovery in FX carry interest (or unwinding of short positions on high-yielders), total return on an equity basis was strong, particularly for South Africa as ZAR also did very well. In contrast, MXN flows are purely based on equity performance rather than realized FX flows. Chinese equities were underwhelming, and this weakened the potential rebalancing score for the CNY. SEK is the only currency which may see strong purchase interest, as the equity market performed poorly, deriving little earnings translation benefit from heavy FX sales.

Forward look

GBP’s current valuations look rich despite the strong risk of stagflation-related concerns in bond markets spilling over into U.K. assets. Consequently, some rebalancing can help release such pressures, but the associated inflation risk will add further weight to the less dovish Bank of England rate-setters who argue in favor of pausing easing. Furthermore, in the broader context of bond market stress, assets which are seen as providing protection in real terms, especially in commodities, can benefit. U.K., Canadian and South African equity markets have high levels of commodity and energy exposure. If concerns over global stagflation remain heading into quarter-end, these markets will be seen in a more positive light despite demand stress, and cheaper currency valuations will encourage additional cross-border flow.

Strong month for Indian government bonds requires FX offset

EXHIBIT #3: MONTH-END FIXED-INCOME REBALANCING SCORES, G10 + CORE EM

_Source: BNY

Our take

Recent developments in long-dated bonds will clearly add to the scope for positive rebalancing for the JPY and USD, as these two markets have been the most affected by bear steepening. On a marginal basis, however, the losses were not excessive, and we stress that gradual steepening for the U.S. and Japan has been a general trend for several months, largely for idiosyncratic reasons. While other bond markets saw healthy recovery flows as markets added duration exposure funded via cash, the U.S. and Japan broadly attempted to limit further sales. Given the Fed and BoJ are in a different policy position compared to their G10 peers, there wasn’t much help in the front-end either and both bond markets did well to limit further losses on the month. Somewhat counterintuitively, this supports the notion that U.S. Treasurys remain favored as a reserve asset, otherwise performance would have been far worse. At the opposite end of the spectrum, Brazil and India were the strongest performers, supporting the broader carry recovery view, which is also reflected in FX. However, high-yield demand during the month would have added to FX rebalancing pressure at the expense of BRL and INR. Meanwhile, GBP and ZAR also face pressures due to strong FX flow performance during the month.

Forward look

Fixed income-driven rebalancing is the core feature of the month. We expect outflows in liquid names such as the EUR, GBP and CNY complementing sales in INR and BRL. Pressure on the CNY should be expected based on the comprehensive asset inflows into the country in recent weeks alone, and we also stress that fundamentals do not support excessive CNY appreciation as risks to price pressures remain to the downside. The selling of these currencies, with their heavy weighting in the USD’s trade-weighted index, will help lift USD holdings, indicating a better-positioned greenback ahead of key events next month.

Bottom line

The dollar will be a modest beneficiary of month-end rebalancing due to the strong incremental hedging seen through May. As we recently highlighted, we believe the market has now found a broad equilibrium level for dollar exposures. Any adjustments up ahead will depend on asset levels rather than additional risk premia being imposed onto the dollar for idiosyncratic reasons. Meanwhile, Fed resilience will also limit additional selling interest though we have seen other central banks step up as well. Dynamics will likely only change as we approach the second half of June, as central banks make rate decisions while trade talks run up again July deadlines.

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