iFlow > Investor Trends
Appearing every Wednesday, Investor Trends provides a deep dive into patterns and behaviors in equity, bond and currency markets around the globe, underpinned with deeper macro insights.
Geoff Yu
Time to Read: 4 minutes
EXHIBIT #1: GBPUSD AND EURUSD HOLDINGS YEAR-TO-DATE (AS A MULTIPLE OF THE ROLLING 1-YEAR AVERAGE)
Source: BNY
Our take
Markets are on the defensive heading into today’s FOMC decision. Given the current level of equity valuations and Fed pricing, the bar for “risk-off” is not high as it will be difficult to identify additional sources of easing in financial conditions for global markets. For U.S. markets, however, the dollar has become an important release valve and we have seen throughout the past few months that its weakness is an important compensatory factor in supporting cross-border flows. Despite our misgivings about European growth and the need for financial conditions to continue loosening in the Eurozone and U.K., by choice or necessity markets are currently pricing out additional cuts by the ECB and BoE for now. Consequently, the risks of additional hedging U.S. assets by Europe-based clients will continue to rise, based on the Fed’s outlook.
Forward look
Scope for change is significant as our data indicate hedge ratios have not shifted much since May of this year. In GBPUSD and EURUSD, current holdings are both close to the rolling 1-year average and net long. This is the “natural state” of holdings in these pairs as GBP- and EUR-denominated investors forward purchase these currencies for hedging purposes. On a purely passive basis, holdings changes should simply reflect changes in asset values of their overseas (largely U.S.-based) asset holdings, which explains the sharp drop in April this year. Presently, EURUSD holdings are running below the 1-year average, which reflects current and forward changes in rate differentials. If the Fed signals a significant shift lower in nominal and real rates, scope for additional hedging is possible as current forward selling of the dollar is not extreme. Given the ECB’s surprising tolerance of EUR strength and the BoE’s limited room for maneuver, there is a window of opportunity for the Fed to perhaps actively “seek” complementary monetary easing through the exchange rate channel. There are risks to this approach, however, as direct pass-through is not helpful while tariffs also exert upward pressure on import prices.
EXHIBIT #2: REGRESSION COEFFICIENT BETWEEN SURGE FLOWS AND INDUSTRY GROUPS’ CORRELATION WITH 2-YEAR BREAKEVEN INFLATION
Source: BNY
Our take
Even with exigent and potential inflation risks, current equity market flows are clearly showing no interest in adding protection in sectoral allocations. Our iFlow “inflation style index,” which looks for evidence of inflation-hedging in U.S. equities through flow behavior, is now at its second-weakest level on record. The low coefficient indicates that investors are not hedging inflation risk, given the extremely poor performance of sectors that are more highly correlated with the 2-year breakeven inflation level. The dominance of growth-based flows in tech is highly distortive: secular investment trends in AI-related capex are still seen as not price-sensitive and will continue to drive the business cycle.
Forward look
We strongly question the sustainability of current inflation “neglect” as behavior in U.S. equities is diverging strongly from sectoral preferences elsewhere. For example, developed and emerging-market commodity sectors have seen material gains in holdings, led, in particular, by metals and mining. Evidently, the move in gold prices has contributed strongly to the trend, but value is also seen as emerging in the energy space, even with continuous upward revisions in over-supply. Furthermore, similar plays are arising in other assets: despite entering easing cycles, Latin American currencies have recently seen a fresh surge, complementing the strong performance of the region’s equity and sovereign debt markets this year. Until recently, we felt the strong Fed anchor had served as a heavy deterrent against excessive FX exposures. These flows suggest that protection against low U.S. real rates is highly sought globally, expect in the U.S. While U.S. exceptionalism has been manifested through high levels of outperformance in earnings cycles in the past, expecting similar divergence in the global price and inflation cycle is a bolder call. Even the prospect of importing inflation from China and APAC, where inflation and real effective exchange rates remain low, has been put in doubt by tariffs. As U.S. real rates stand to fall further, we believe a sharp rebound is needed in inflation-related flows.
EXHIBIT #3: DAILY FLOWS INTO U.S. TREASURY SECURITIES WITH MATURITIES OF 10Y+, TOTAL AND CROSS-BORDER
Source: BNY
Our take
Additional easing in U.S. financial conditions is materializing through the rate channel. Despite stagflation fears persisting throughout the developed world, price action in recent weeks have been favorable for U.S. Treasurys’ reserve status, as gilts and OATs faced their own brief episodes of sovereign stress. Our data show that since the beginning of July, the 10y+ part of the U.S. Treasury curve has remained well supported, with domestic and cross-border investors both participating. More recently, however, purchases are now materially skewed toward domestic participants, though cross-border investors are more in a holding pattern and not looking for additional performance in duration. Given the dollar has continued to weaken, this does represent a behavioral shift compared to Q2: a weaker dollar and higher yields are necessary conditions for a cross-border surge flow, and the Fed appears to be inhibiting the latter.
Forward look
We remain confident that the U.S. Treasury market will end the year without material cross-border outflows. The lack of alternatives aside, current dollar weakness will start to pressure yields globally while fiscal scrutiny has spread to much of the G7. Within G10, Australia is probably the only exception which offers ample liquidity and strong ratings backing. Nonetheless, over the long term we do expect the U.S. Treasury market to become more self-funded as external surpluses continue to decline, and any translation would ideally take place in a low-yield environment. However, we remain concerned that general pricing on U.S. inflation, across asset classes, seems too benign and Fed messaging on real rates will require very careful calibration.
