Key Highlights

• High-carry FX seeing demand but holdings an ongoing hindrance
• European equities struggling for new narrative as short utilization continues to grow
• Volatility collapse and renewed MENA focus driving interest in frontier markets

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FX Carry interest present but holdings setup less supportive

EXHIBIT #1: WEEKLY SCORED FLOW VS. SCORED HOLDINGS, HIGHER-CARRY EMEA AND LATAM CURRENCIES

_{Source: BNY iFlow}

Risk appetite has improved markedly in recent weeks as the U.S. reaches trade détente on multiple fronts, with China being the most important near-term settlement. After a stumbling start, our flows indicate that various thematic strategies are now in place to take advantage of the declines in volatility. In foreign exchange, carry trade unwinding has ended and high-yielding names in EMEA and Latin America are finding bids (Exhibit #1). We expect such flows to continue but doubt conviction levels will be high for such flows.

Our take

There are two major hindrances to carry support. Firstly, despite the strongest wave of carry unwinding in nearly eight years, as identified in iFlow Carry, the majority of high-yielding currencies remained in an overheld position, led by Latin American currencies. Consequently, capacity for further improvement is limited and we expect a holdings range of 1.0-1.5 to prevail. Secondly, the macro cycle is in a different place compared to 2023 and even with the unwinding of U.S. tariffs, globally growth expectations have been affected, resulting in a generally dovish policy bias in emerging markets, thereby hindering carry flows.

Forward look

The dollar’s valuations are now much more attractive relative to most low-yielding currencies. If the carry trade is to return, we expect a stronger long-dollar bias, but there also won’t be high levels of dollar-funded positions into high-carry currencies to complement risk appetite. While emerging economies in a current account deficit position will attempt to stabilize their own currencies, many have also expressed an intent to take advantage of any opening to ease policy. We continue to see limited interest in using FX to express a view on the recovery in risk appetite.

European equities sentiment continues to deteriorate as trade talks lag

EXHIBIT #2: EQUITY SHORT UTILIZATION VS. SCORED HOLDINGS IN DEVELOPED EMEA EQUITIES

_{Source: BNY}

Many equity markets now look set to erase their post-“Liberation Day” losses, and we believe European equities are in a very different place and risk becoming a casualty of the rotation back into regions most affected by trade gyrations. In developed markets, Europe continues to lead performance year to date, but investor doubts are creeping in. Short utilization has surged since March and pressure will only increase if earnings and domestic policy begin to disappoint.

Our take

The U.K. and China reaching initial trade settlements with the U.S. has likely come as a surprise to the EU. In U.S. Treasury Secretary Scott Bessent’s own words, the EU suffers from a “collective action” problem which will delay decision-making in the block. This matters for European equities because the re-rating in the local market this year was largely contingent upon the view that the EU can move away from this near-default position and act quickly, especially on domestic investment. The pace at which Germany amended its constitutional debt brake in favor of defense-driven fiscal spending was an initial sign of resolve, but doubts have crept in, compounded by Merz’s parliamentary slip up late last week.

Forward look

The fact that Europe’s retaliatory tariffs are clearer than any outline of a trade deal with the U.S. points to clear risks that the EU will be adversely affected by reciprocal and sectoral tariffs as the 90-day suspension ends. Even with re-pricing in favor of domestic investment, growth is currently inconsistent with valuations, such as the DAX’ 16.5x price-to-earnings ratio for this year vs. the sub-14 average for the past two years. The domestic investment supposed to lead to the re-rating is still lacking, while surveys even point to household sentiment deteriorating more rapidly than corporate equivalents, which are more exposed to tariffs. Markets are clearly expecting a correction and, ECB easing aside, there is not enough evidence that policy offsets in support of growth are forthcoming. Consequently, a weaker EUR for the rest of Q2 is clearly the path of least resistance.

Moves up the risk curve seen in EM/FM duration

EXHIBIT #3: WEEKLY AVERAGED SMOOTHED FLOWS, TURKEY AND EGYPT

_{Source: BNY}

High-yielding currencies continue to enjoy moderately positive positioning, which is hindering additional exposure. However, emerging market bonds have not seen material inflows in recent years due to a robust U.S. Treasury securities market which offers yields and liquidity in equal measure. While the recent talk of Treasurys losing reserve status is overblown, the volatility has rekindled interest in broadening allocations in government securities. Even bond markets considered closer to the frontier spectrum, such as Turkey and Egypt, are seeing clear recovery interest.

Our take

EM bonds struggled in April as markets sought safety in cash and equivalents, but the episode did generate greater appreciation for policy credibility and competence in execution. Strong inflows into Brazilian debt as shown in iFlow exemplify such interest. These are factors where emerging markets have generally demonstrated clear improvements over the past few years, most notably on the fiscal side, with fiscally hardline finance ministries receiving support from central banks in avoiding fiscal dominance. Egypt was the best-performing emerging/frontier bond market for much of last year after its initial FX adjustment and markets are now expressing confidence that reforms can continue apace.

Forward look

Due to the high level of nominal yields in Brazil, Turkey, Egypt and select other countries, there is a large buffer in place to generate high real rates in support of their respective bond markets. The anchoring assumption remains for energy and commodity prices to remain subdued while domestic fiscal restraint remains in place. Given the recent changes in overall production guidance from OPEC+, we are increasingly confident in headline inflation staying low. For much of EM, this also eases pressure on fiscal subsidies and helps redirect resources toward structural reform. From the lowest possible base, we continue to see EM duration outperforming, but asset managers will attempt to limit FX risks.

Bottom Line

Risk appetite is clearly recovering, and we are cautiously optimistic that risk-positive flows will extend into the summer. However, the market is now far more selective in its allocations, and liquidity ratios will remain at a premium. FX carry trades will stabilize at best, while bond markets with improving real yields anchored by fiscal restraint and structural reform will be the most preferred markets – in both EM and DM. Capitol Hill perhaps needs to bear this in mind as it seeks to complete a U.S. budget in the coming weeks. Meanwhile, time and patience are running out for Europe to justify market-leading valuations and show Secretary Bessent that, with proper execution, “collective action” is one of the EU’s greatest strengths.

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