Key Highlights

• High-carry retreating in an orderly manner
• Cross-border investors more partial to European growth
• Treasurys and corporate credit short utilization diverge

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High-carry currencies being sold, but overheld positions intact

EXHIBIT #1:  SCORED HOLDINGS VS. WEEKLY SCORED FLOW, JULY 1 VS. JULY 14

_Source: BNY

Our take

Our iFlow Carry indicator continues to have positive statistical significance, indicating strong alignment between the 10-year yield on currencies versus their realized flows. However, when this is the case there is a strong risk of mean reversion, as all indications are the strategy is becoming crowded and there is better risk-reward in looking to fade the move. Although there isn’t any material change in the scale of alignment (calculated using a rank correlation), we note that within the currencies normally associated with carry trades – namely EMEA and Latin America – there is a clear shift toward sales over the past week (Exhibit #1). In contrast, as of the beginning of the month, on a weekly scored flow basis, every single currency in the two regions was net bought, though admittedly PEN purchases were strong on a surge flow basis. Despite the reduction, the holdings pattern remains in place as all Latin American currencies we track are currently overheld, whereas CZK and PLN are the exceptions and mostly for idiosyncratic reasons (CZK’s balance of payments normally provides it with funding status). Consequently, despite some reduction in exposures, there are opportunities to take further advantage of a carry reversal.

Forward look

We believe that the market is now looking to add to defensive positioning, and moving away from carry exposure is a cost-efficient way to do so. However, during the run higher in carry alignment, our data indicate that low-yielding currencies were also materially sold. For a true carry unwind, these currencies outperforming would need to be part of the process, especially those of surplus economies anchored by low rates in APAC. We believe there is already a strong valuation case for such an adjustment, and with global trade alignment taking place, these economies will need to restructure growth models toward domestic demand. The flow of funds to the U.S. and developed markets elsewhere will soften and remove a traditional source of depreciation pressure on such currencies. This process will be gradual, but we would not underestimate the scale of new-found tolerance for currency strength amongst traditional export-driven funders.

Cross-border equity positions still favor sectors which may see a demand lift

EXHIBIT #2: TOTAL AND CROSS-BORDER HOLDINGS IN DM EMEA, SECTORAL BASIS

_{Source: BNY}

Our take

The EUR appears to have topped out, as markets are wary of a tail risk of a more dovish than anticipated outcome from next week’s policy decision. Our data show that cross-border hedges in the EUR continue to grow, and current valuations are advantageous to lock in. However, the changes may also reflect sustained positive performance in developed European equities. Due to the prevailing “U.S. exceptionalism” investment thesis seen over the last few years, cross-border investors have been underweight European equities but the new investment/domestic-demand narrative has changed proceedings. We find that relative to combined client base (cross-border and local) holdings (Exhibit #2), the sectors with the largest over-allocations are clearly areas with the most to gain from stronger domestic demand and linked to defense, such as industrials and IT. Consumer discretionary and energy are also performing well, which also speaks to a stronger growth narrative. However, these are areas where the absolute levels of holdings are weak across all client segments.

Forward look

We have highlighted our concerns about overextended and concentrated holdings in European equities due to the domestic demand and defense themes. There has been very little adjustment even as realized growth and price data are showing signs of peaking. The ECB’s recent change in tone regarding the euro is a sign of such concerns. Given the currency’s input into Eurozone and broader European financial conditions, a policy push for a weaker currency will initially be seen as positive for risk sentiment, similar to the “bad news is good news” narrative in the U.S., whereby equity markets rally on the basis of earlier Fed easing. Due to the earnings translation effect, cross-border allocations will likely increase their hedging of European equity exposures, especially in sectors where performance is the strongest. Either way, a more defensive approach is needed for such allocations, and stepping up hedging is preferable to rotating out of allocations benefitting from a secular change in Europe’s growth structure.

U.S. corporate credit not sensitive to tariffs, benefiting from Fed pricing

EXHIBIT #3: CHANGE IN SHORT-UTILIZATION, U.S. TREASURYS VS. U.S. CORPORATE CREDIT

_{Source: BNY}

Our take

U.S. rate expectations remain in a state of flux but caution surrounding the direction of travel of U.S. fixed income is rising again. The market’s reaction to the latest CPI data indicate a market which continues to err on the side of higher inflation premia. Since mid-June, our data indicate that short-utilization in U.S. Treasurys has picked up materially, though it is still below the levels immediately after “Liberation Day” (Exhibit #3). Presently there is strong asymmetrical risk to the downside in real rates, which is in line with the bear-steepening narrative we highlighted at the beginning of the year. Surprisingly, there is very limited change in short utilization for U.S. credit. This asset class has structurally low short-utilization due to market structure, but even the lack of a stronger reaction in April points to a different reaction function for corporate credit to lower real rates, and lack of a structural diversification flow from foreign investors.

Forward look

As highlighted in this week’s Short Thoughts, our view is that rising yields are a symptom of rising government debt around the world. Clear potential growth advantages such as demographics and productivity gains have not been able to compensate for the rise in outlays. Our data indicate the U.S. financial account remains relatively sold due to a lack of alternatives, but there has been a greater cross-border shift into equity-based holdings by private sector funds, tightening financial conditions for government paper on a relative basis due to the latter’s general dependency on sovereign allocations. Consequently, a weaker dollar and higher yields will continue to feature over the long term. In contrast, robust valuations and lower real yields at the front end are supportive of corporate credit, as liabilities are easier to finance in real terms. This is unlikely to change, as issuance has declined in recent years due to higher rates, and bankruptcy rates remain well within historical norms.

Bottom line

Although risk sentiment remains buoyant, there are ample signs of over-extended positions and investment themes which are at risk of correction. Our data indicate that defensive postures are starting to rise, albeit from very low levels. Such steps are prudent ahead of summer trading conditions but also suggest that confidence in current risk-positive narratives continuing has likely peaked.

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