Key Highlights

• Carry FX holdings now positively aligned with yields
• Latin America the surprise outperformer in equity diversification
• Despite assertive Fed, foreign investors are returning to U.S. credit

View chart pack

High-yielders now generally overheld as EM duration

EXHIBIT #1: CURRENT HOLDINGS VS. 10-YEAR YIELD

_Source: BNY

In yet another sign of normalization in sentiment, our iFlow Carry indicator has turned statistically significant and positive on a holdings basis. This implied that there is material positive alignment between the holdings of a currency and the 10-year government bond yield. In Exhibit #1, we list the top five and bottom five currencies by yield, and this relationship remains broadly in place. The only expectations are ZAR (marginally) and JPY.  Meanwhile, we note that iFlow Carry is also showing moderate alignment between flows and yield.

Our take

On the one hand, investors are clearly favorably disposed toward higher-yielding currencies. Despite obvious risk catalysts, there is little sign of volatility picking up aggressively, leading to carry positions offering better risk-reward. However, judging by the levels of holdings, we believe conviction in these trades is not strong. Only COP is above its 1-year average in holdings, while the current magnitude of funder positions amongst “liquid” low-yielders such as CHF, CNY and even SEK are all below their 1-year averages. TWD is the only very strongly underheld currency, but even so we believe these positions are highly exposed to central bank intervention intent and can unwind quickly, independent of the broader risk environment.

Forward look

There is a strong likelihood that iFlow Carry, on a flow-adjusted basis, will soon turn statistically significant and positive. When that happens, we believe markets will need to exercise greater caution, as this would indicate the strategy is becoming increasingly crowded. Even if the U.S. dollar no longer strengthens during risk aversion, it’s worth noting that during the April risk-off period, investors significantly sold higher-yielding currencies in favor of cash equivalents. At the same time, all five low-yielding currencies we track have large current account surpluses, which will support greater home investment bias – driven by U.S. trade rebalancing – going forward. As a result, the risk-reward profile for carry trades is likely to become structurally less attractive, requiring more tempered expectations around future returns.

Latin American equities ignore tariffs, leading global equity flows

EXHIBIT #2: EM AMERICAS SCORED EQUITY HOLDINGS VS. GLOBAL SCORED EQUITY HOLDINGS

_{Source: BNY}

Despite the general improvement in risk sentiment through May, the recovery in equity markets has been stop-start and on an aggregate basis globally, iFlow data indicate current holdings levels remain well below the highs from the beginning of the year. However, the one regional exception to such flow and holdings trends is Latin America. Despite some initial concerns surrounding the trade relationship with the U.S. and prolonged weakness in the Chinese economy affecting commodity receipts and general growth in the region, holdings have shown steady improvement since late January. Remarkably, the April global risk aversion episode barely registered.

Our take

Latin America is the best-performing region year-to-date despite the lack of obvious re-rating factors, such as defense investment in Europe and technology/AI in China. Prior under-positioning has played a role and due to relatively small capitalization levels, equity diversification flows away from “U.S. exceptionalism” likely generated an outsized impact on the region. Even so, closing a near 20-point gap in holdings levels relative to global allocations is impressive. However, this raises the bar for future performance as earnings growth is needed to justify over-weighting versus the benchmark.

Forward look

The MSCI Latin America index is currently trading at a high single-digit price-to-earnings ratio, which is well below the averages seen over the previous decade. However, we do not see those levels as realistic given global growth – especially China – has become far less commodity-intensive. On the other hand, the prospect of sustained dollar adjustment lower, amplified by high real rates in the region, offers good risk-reward and we believe maintaining a light weighting gap over global and developed market equities is acceptable. The broader challenge is for Latin America to grow based on domestic demand without risking fiscal sustainability. The region came out of the pandemic with strong results on this front, while central banks continue to anchor real rates. Sterner tests await if global growth slows, especially in a market with very low tolerance for fiscal dominance in any economy.

Cross-border corporate interest unfazed by U.S Treasury risk

EXHIBIT #3: WEEKLY SMOOTHED FLOW, U.S. IG AND U.S. HY

_{Source: BNY}

For the first time this quarter, we have seen buying of both U.S. investment grade and high yield credit by cross-border investors. Combined, corporate debt flows into the U.S. are now at the strongest levels this year. Globally, this asset class has performed very poorly over the past two years – facing selling during aggressive Fed hikes and struggling for allocations during the tech-driven equity run of U.S. exceptionalism.

Our take

Current inflows confound the usual narratives: the Fed moving away from strong easing and bear steepening in the U.S. Treasury curve should have led to accelerated selling. Clearly, cross-border investors are seeing value in spreads, and the weak dollar is probably playing a role. Given the risk profile for corporate credit, these flows are not dissimilar to long-end Treasury purchases by cross-border investors during recent rounds of dollar weakness and curve steepening. Furthermore, allocations to U.S. credit are likely very light given the selling seen over the past few quarters, and these inflows will not materially add to risk exposures.

Forward look

If inflows continue solely based on asset allocation adjustments, i.e., correcting a materially underheld positioning compared to historical levels, then current flow strength is justified. As seen in recent cycles, credit weakness will be highly correlated to the state of the U.S. economy, which remains on an even footing despite recent shocks. Cross-border demand is being amplified by a weaker dollar, but U.S. growth and household resilience is a necessary condition to sustain or even improve on current performance. 

Bottom line

Risk appetite remains broadly resilient heading into June, despite ongoing concerns over tariffs and recent volatility in global government bond markets. However, asset allocation trends are showing a clear shift toward greater selectivity. Strong flow performance in Latin American equities and U.S. corporate credit suggests that previously underweight exposures are becoming increasingly attractive as investors look beyond traditional U.S. assets like equities and Treasurys. That said, these alternative markets remain inherently sensitive to both U.S. and global growth dynamics. As such, we view the recent positioning shifts as tactical for now, pending further clarity on the trajectory of the U.S. economy.

Chart pack