Key Highlights

• Sharp drop in carry interest points to caution
• iFlow Mood also turns negative as equity sales surge
• Cross-border investors moving back into U.S. duration

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FX: iFlow Carry drops sharply from high statistical significance

EXHIBIT #1: IFLOW CARRY, FLOW AND HOLDINGS BASIS

_Source: BNY

Our take

In a surprise shift, iFlow Carry entered statistically significant and positive territory last week, but as we highlighted at the time the fundamentals look too weak to support a sustained move. There was very little indication of demand for high-yielding assets; instead, it was the dollar’s strong performance against low-yielding currencies that pushed low-yielders toward very weak flow levels and generated the signal of positive statistical significance in iFlow Carry. Furthermore, currencies like JPY, CHF and CNY saw selling more for idiosyncratic reasons rather than a general market search for optimal funders. There was a sharp drop this week in iFlow Carry back to neutral (Exhibit #1), and signs point to a swift mean reversion, suggesting risk sentiment will continue to weaken. For example, some of the most overheld over-held carry currencies, such as HUF and ZAR, are already facing heavy hedging flow.

Forward look

A bigger test for carry sentiment will be holdings. While iFlow Carry on a flow basis has struggled to sustain positive momentum, there has only been one strong episode of carry unwinding – right after “Liberation Day.” However, these flows were swiftly reversed and high-carry currencies remain moderately overheld. As currency holdings are slow moving in nature, a rapid shift will take not just sales but a sharp rise in flow volumes as well – which was the case in April. Given that trade tensions were the biggest trigger during that round of carry liquidation, there are parallels with current moves. Meanwhile, last week’s central bank decisions in EM generated several dovish surprises, which indicates that easing cycles are being brought forward by central banks with the capacity to cut. A full repeat of price action in April and May is not our base case, but overheld currencies in EMEA and Latin America are now at risk of a significant adjustment.

Equities: Stronger incremental equity sales relative to bonds point to risk aversion

EXHIBIT #2: IFLOW MOOD AND ITS UNDERLYING EQUITY/FIXED INCOME FLOW DRIVERS

_Source: BNY

Our take

In another indication of deteriorating sentiment, iFlow Mood has turned negative again after a brief period of neutrality. We define behavioral change by looking at the difference in surge flow (calculated as the average of 65-day scored flow difference from the average 130-day scored flow) in global equities against developed market front-end bonds. By this measure, sentiment has been soft for much of the year, but when both asset classes are being net bought it is difficult to qualitatively state that markets are risk-averse. For much of the year, front-end yields also held well so it was not difficult to reconcile good surge flow into both short-dated instruments in the G7 (especially in USD and GBP instruments) in addition to equities. The difference now is that the latest round of “risk-off” as characterized by iFlow Mood is based on a sharp deterioration in surge flow in equities (Exhibit #2).

Forward look

The worrying aspect for markets is that the turn back into “risk-off” reflects medium-term flow behavior so sentiment was deteriorating, or at least stagnating, before recent trade tensions entered the fray. This in part reflects the elevated level of flow and holdings in equity markets, thereby raising the bar for further purchases and lowering the bar for sales. Momentum favors continued deterioration: demand for front-end paper is already rising while equities are net sold. This process accelerates the decline in iFlow Mood. There will be a case for mean reversion if current trends extend, but markets remain well above the lows set in Q2 after “Liberation Day,” and further stress in U.S.–China trade relations certainly risks revisiting those levels.

Fixed income: Cross-border clients “twisting” Treasury exposures

EXHIBIT #3:  SCORED FLOW IN U.S. TREASURYS FOR NON-USD ACCOUNTS, 10Y+,1–3Y AND GAP

_Source: BNY

Our take

Should trade tensions begin escalating again, markets may revisit the “de-dollarization” or “U.S. Treasury diversification” theme prevalent in Q2. In our view, this was more talked about than actioned among our non-USD accounts. According to our data, throughout March and April as tensions began to escalate cross-border investors were consistently active buyers of the back-end relative to the front-end (Exhibit #3). Liquidity differentials between maturities may have played a role in this respect: the weighted average maturity of the U.S. Treasury market is well below six years so the quantum of sales in the front-end would likely be bigger. Nonetheless, as higher yields and a weaker dollar were seen as sufficiently compensatory for the risks involved, we can see non-USD-denominated investors were very active in lengthening their maturity exposures through the entire quarter, before taking some profit later in the summer. More recently, cross-border flow into the long-end of the Treasury market has moved back into positive for the first time since August, but this client segment continues to actively reduce front-end exposure, where there is greater sensitivity to interest rate differentials. Consequently, the gap between the relative strength of purchases in the 10y+ part of the curve versus short-term dates is now at its widest point in close to four months.

Forward look

Current flow trends show that international clients are very comfortable in adding to duration in their Treasury portfolios. In the past, “operation twist” has been seen as a way for a central bank to ease financial conditions without actively increasing the size of its balance sheet, and it seems non-USD accounts are already heading in this direction, at least reflecting further easing of financial conditions. Coupled with steady improvement in dollar holdings and performance, the safety status of U.S. assets seems secure for now. The Fed’s change in stance compared to April is playing a clear role in a different market response, while the current shutdown and the sharp rise in tariff-related revenue (essentially a tax increase) may also be seen as mitigating the U.S.’ fiscal position – although they are not exactly viewed as optimal paths to fiscal consolidation. Either way, our data continue to show that cross-border clients feel adequately compensated for their long-dated Treasury holdings, and front-end flows will also likely benefit if risk-aversion picks up as USD liquidity preference strengthens.

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