Key Highlights

• EURUSD continues to underprice Eurozone disinflation
• CEE already overpricing peace dividend
• Hong Kong asset moves becoming a pure flow story

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EUR’s reaction function to inflation differentials has broken down

EXHIBIT #1: EURUSD VS. 2Y BREAKEVEN DIFFERENTIAL, EUR AND USD ZERO-COUPON INFLATION SWAPS

_{Source: BNY, Bloomberg}

Our take

ECB President Christine Lagarde will probably not face as much scrutiny on stagflation risk as her peers in Jackson Hole. Based on the ECB’s June Staff projections, the baseline for inflation is a decline to below target in 2026 and 2027, while real GDP is expected to improve from current levels. Furthermore, the shift in fiscal mindset over the past six months even points to more “productive” public investment into competitiveness, and the security situation in Europe will sustain such flows for years to come. The euro and Eurozone assets have benefited strongly from this narrative, but this doesn’t mean that the currency’s relationship to price developments is adequately priced. The asymmetry of risks at present means high market sensitivity to stagflation risk, but the EUR’s current performance looks to be completely disregarding disinflation risk: through much of last year, Eurozone breakeven inflation was falling well below U.S. equivalents and driving EUR weakness. Currently, there has not been much improvement in inflation differentials, implying extended loose policy from the ECB, but this is not showing up at all in EURUSD performance (Exhibit #1).

Forward look

We maintain the view that current EURUSD levels are now high enough to edge the ECB closer to the “alternative scenario – severe” set of forecasts detailed in June, which would push inflation down to 1.5% and below target through the entire forecast horizon. By default, this would require corrective action. Stagflation does degrade portfolio performance in affected economies, and the market is clearly concerned about the growth and demand outlook in the U.S. However, if such fears are realized, there will be a knock-on external impact on the Eurozone and beyond, compounding the headwinds already generated by the current trade environment. We do not expect a full reversion to last year’s EURUSD levels, so even with a breakeven gap of above 100bp, EURUSD can hold well above 1.10, but the market’s “benign neglect” for the EUR simply out of USD caution risks a growth and price backlash in the Eurozone itself. President Lagarde on Wednesday already hinted at movements in the ECB’s September forecasts due to trade, and this would require a more defensive posture ahead of that policy meeting, irrespective of the Fed outcome.

Hungary priced and held for perfection

EXHIBIT #2: SCORED HOLDINGS YEAR-TO-DATE, FX, EQUITIES AND FIXED INCOME

_{Source: BNY, Bloomberg}

Our take

After 72 hours of intense discussions, markets are currently none the wiser regarding progress toward a settlement in Ukraine. However, much like how risk assets generally are behaving at present, “no news is good news” and the most affected assets continue to perform well. However, unlike the reaction to the first Zelensky–Trump White House gathering earlier this year, which accelerated a comprehensive re-rating in European defense and sovereign assets, the current reaction function to assume that the status quo surrounding defense investments will remain. The U.S.’ ambiguous pledges of security guarantees looks sufficient for now to maintain current pricing of strong investment flows. We continue to see Central and Eastern Europe (CEE) performing well in terms of trend growth. Meanwhile, despite strong fiscal impulse, policy is restrictive enough for markets to appreciate owning high real yields. However, we note that there is almost no risk premia at all in any asset class in the region based on holdings, which is clearly unsustainable.

Forward look

Hungary is the most extreme case and probably the asset market which is most at risk of a correction. Furthermore, historically Hungary also has had the most difficulties in unlocking (or unblocking) European Union funding due to institutional issues. These risks have not gone away but appear to have been totally disregarded in positioning – which was not the case in the past. Similar challenges in relations between the EU and CEE member states loom up ahead. Even if the funding is undeniably available over the medium to longer term and large disbursements in the region support the growth-and-returns case, we believe additional risk premia is necessary, and for now the most efficient path is to increase FX hedge ratios, especially if softer European growth in H2 reopens the case for more assertive easing in CEE.

HKD volumes point to heavy asset-related activity

EXHIBIT #3: MONTHLY SMOOTHED SCORED VOLUMES, HKD, CNY AND USD

_{Source: BNY, Macrobond}

Our take

FX volumes have mostly been softer over the past quarter, especially after the exceptional level of volatility in early Q2. During periods of risk recovery, asset volumes move toward one- rather than two-way flows. For custody clients with passive FX interest, associated currency volumes also tend to decline. However, when there is a rise in marginal flows in asset demand, this will also be reflected in foreign exchange activity as hedging needs rise, too, assuming there are no material changes in hedge ratios. As such, we find the recent surge in HKD volumes of particular interest (Exhibit #3). Global FX volumes, using USD as a proxy, are running at around 1.5 standard deviations of the monthly average while CNY interest is half that level. Yet, HKD is now running at close to 2.5 standard deviations of monthly volumes, and the surge has been very recent – almost fully aligned with the gains in regional equity markets and record levels of inflows through the Shanghai–Hong Kong connect program.

Forward look

We continue to see a strong case for re-rating in Chinese and Hong Kong stocks and the ongoing steepening in the Chinese government bond curve points to rotational flows proceeding apace. Given our data is institutional in nature, the surge in HKD figures point to higher institutional demand as well, perhaps as part of the long-term process to diversify away from the dollar and U.S. assets. However, we remain very concerned that the surge flow by regional retail investors is far higher, and the markets in question have historically relied disproportionately on retail flows to drive activity, which has led to mispricing and repeated large-scale corrections. Until the structure of participants change, cross-border institutional flow, especially from U.S. and European investors, will remain limited, and this is even before addressing some of the geopolitical factors in play.

Bottom line

Markets are fully justified in looking ahead to some of the mispricings in U.S. asset markets ahead of Jackson Hole. Evidently, stagflation fears are growing and the prospect of further Fed pivots would leave equities and many parts of the Treasury curve exposed. However, there are other areas of complacency – especially in a pro-risk manner – which require close vigilance as we approach the end of the summer. Many idiosyncratic narratives, especially positive ones for the Eurozone, CEE and Asia, are running ahead of fundamentals. Any correction will be amplified if U.S. financial conditions begin to re-tighten, but without any external demand or domestic productivity growth to cushion the adjustment.

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