Key Highlights

• Key commodity FX names most at risk from rebalancing
• Watch for rotation risk in Eurozone asset allocation
• Front-end demand continues to rise in APAC

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Commodity names such as ZAR, NOK and BRL lead rebalancing need

EXHIBIT #1: MONTHLY REBALANCING SCORES FOR 15 MAJOR CURRENCIES

_Source: BNY

Based on our flows for June, our data only identified what can be characterized as surge flows in NOK, ZAR and JPY. The two former names point to strong commodity impulse, which aligns with some of the price action seen throughout the month. Over the past quarter NOK holdings approached extreme levels. Coupled with strong equity performance over the month, we had expected very sharp NOK sales or hedging flow for rebalancing purposes for quarter-/month-end, as the change in holdings alone warrants an adjustment. This was already taking place to some extent but Norges Bank’s switch toward net sales of FX to fund government outlays could complicate this view. Meanwhile, ZAR is top-ranked in both FX and asset flows, which speaks to the improvement in fundamentals, but we doubt markets are in a position to add excessively to even larger EM markets at this point and FX hedges will have to give way. For net sold currencies, the abnormal flow scores are not high and will be offset by generally strong asset performance.

Our take

Based on equity returns and FX flow, NOK, ZAR and CAD face the highest rebalancing risks. These markets all performed well in both asset classes, resulting in overexposure. On a cross-border basis, NOK and ZAR are particularly at risk due to the dominance of cross-border interest, but their starting positions in holdings are very different. ZAR and NOK were the only currencies with strong fixed income-based rebalancing scores and BRL may also face some pressure based on duration performance. BRL’s FX flows were moderate but fixed income performed very strongly, contributing to rebalancing needs. 

Forward look

There was a clear commodity bias for month/quarter-end rebalancing. A combination of yields, domestic fundamentals and idiosyncratic gains in energy/commodity markets through June likely contributed to asset returns, which in turn generated rebalancing needs. Overall, we see the sales in these currencies as healthy, as global fundamentals are still too weak to sustain stronger terms of trade. There is a valuation (and dollar diversification) case to add to “real asset” exposure in commodity-based economies, but we only see a case for duration up ahead as global disinflation is the prevailing price trend. Hedge ratios will need to remain high, as these central banks take advantage of a more dovish Fed to bring forward their own rate cuts, while retaining a strong real yield buffer.

Drop in Eurozone equity holdings may further support bond inflows

EXHIBIT #2: YEAR-TO-DATE DEVELOPED MARKET ENERGY AND MATERIALS INDUSTRY GROUP HOLDINGS

_{Source: BNY}

We expect many speeches this week at the ECB’s Sintra forum to reflect on a moment of opportunity for the Eurozone. For all the criteria set by ECB President Lagarde and her peers, proof of stronger haven/reserve interest in the currency will be determined by the strength of comprehensive asset inflows into the Eurozone’s assets. If U.S. exceptionalism was defined by broad-based cross-border investment into U.S. equities and bonds while the dollar was strong, the euro would need to match that. Euro strength is playing its part this year, but we believe the equity outlook for the Eurozone will be more challenging in Q3. Our data show that equity holdings are already dropping from the highs and a stronger EUR will only add to earnings pressure.

Our take

In April, even when the world was arguably at “peak demand” for U.S. alternative assets and the Eurozone was the only viable alternative, the rotation away from equities and into fixed income was clear. Through May, the process reversed, but if there are concerns over Eurozone holdings becoming overextended relative to fundamentals, the signs are again for rotation rather than adding to FI exposures to support reducing overall allocations in the U.S. (Exhibit #2). The current breakdown of flows into Eurozone sovereign debt continues to support Germany, while Italy is also seeing stronger inflows. France is the under-performer despite the favorable liquidity position, indicating fiscal dominance in the country remains a concern.

Forward look

This week’s downside inflation surprises across the Eurozone but particularly in Germany raises questions over the notion that the ECB is “done.” ECB Chief Economist Philip Lane was very careful in his language this week, noting that the economic cycle is “done” but vigilance over policy deviations is still necessary. The ideal scenario is for equity holdings to limit declines while duration interest picks up accordingly, as the latter need not come at the expense of the former. On the other hand, as we have highlighted for cross-border U.S. Treasury flow, when valuations are high relative to fundamentals (credit risk, yields, etc.), then currency weakness is needed to compensate. We believe the September ECB meeting remains “live” and this will support Eurozone duration, but most likely at the expense of equities and euro softness as the “euro moment” remains far from reality.

Preference for surpluses continues to support APAC cash equivalents

EXHIBIT #3: SMOOTHED FLOW FOR SINGAPORE CASH AND SHORT-TERM (CAST) INSTRUMENTS AND APAC <1 PAPER

_{Source: BNY}

Clamor for U.S. Treasury equivalents may not be as strong amid the current U.S. fiscal process compared to Q2, but behind the scenes light rotation and the search for “alternatives” is continuing apace. Ultimately, in an era of fiscal dominance risks, the market will remain partial to economies which remain amply funded by high levels of external surpluses and domestic savings. As the Fed continues to move in a less hawkish direction, the lack of yield support is becoming less relevant. The strength of the Swiss franc, which now has effective negative rates after the June Swiss National Bank decision, is the best example of super-AAA cash demand. APAC may not have the ratings anchor apart from Singapore, but savings are ample and not in danger of any structural decline. The quarter-end surge into the region is notable (Exhibit #3), and unsurprisingly Singapore is leading the way.

Our take

Defensive flows are picking up ahead of key deadlines surrounding tariff deals. Japan has yet to reach an agreement with the U.S. and cross-border investors do not want to be under-funded in savings-based currencies if volatility picks up again. Given the dollar’s correlations to trade-based shocks, these currencies all face appreciation risk as overseas positions are unwound to fund domestic support or as a simple asset allocation choice to move away from the dollar. Lower surpluses due to a drop in exports to the U.S. will have a similar impact and these positions are defensive in nature.

Forward look

While we are cautious on chasing G10 pairs against the dollar as much of the post-tariff price action in FX is already reflected in flow and cash positioning, the USD can continue to adjust against APAC as valuations remain favorable. The Fed’s current path has also given central banks in the region more space to cut rates. If cash exposures were going to rise anyway, surge flow before the Fed moves and allows APAC central banks to follow is understandable. We continue to see USD downside vs. savings-heavy names in the region as cash and liquidity exposures accumulate, but of course subject to central bank tolerance levels as developments in the TWD and HKD markets have shown.

Bottom line

While we are cautious on chasing G10 pairs against the dollar as much of the post-tariff price action in FX is already reflected in flow and cash positioning, the USD can continue to adjust against APAC as valuations remain favorable. The Fed’s current path has also given central banks in the region more space to cut rates. If cash exposures were going to rise anyway, surge flow before the Fed moves and allows APAC central banks to follow is understandable. We continue to see USD downside vs. savings-heavy names in the region as cash and liquidity exposures accumulate, but of course subject to central bank tolerance levels as developments in the TWD and HKD markets have shown.

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