Key Highlights

• Japan’s cash and short-term instrument (CAST) flow is first sign of extreme yen weakness
• New Zealand’s central bank unlikely to support its currency or asset flows
• Commodity currencies at renewed risk from terms of trade shifts

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Cross-border investors increase Japanese cash-equivalent exposure

EXHIBIT #1: JAPANESE CAST FLOW VS. JPY WEEKLY SMOOTHED FLOW

_Source: BNY

Our take

The USDJPY exchange rate continues to rise on concerns over the direction of Japan’s monetary and fiscal policy. Additional economic strains are also being priced in amid rising geopolitical tensions.

We believe that the key driver of the yen (JPY) remains the Bank of Japan’s (BoJ) ability to retain the policy space to hike rates. A lack of confidence in this regard has undermined JPY flows since mid-September.

Recent meetings between BoJ Governor Kazuo Ueda and key government officials have provided little clarity on policy continuity. However, government advisors have clearly expressed a desire for the BoJ to hold off on tightening. The yen’s failure to benefit from recent equity market volatility is another sign that domestic policy is undermining traditional valuation drivers.

On a balance-of-payments basis, the JPY already appears weak, but its inability to strengthen even as global rates decline is a new development. Even with a “policy discount” in place, we see tentative signs of stabilization in cross-border JPY sentiment.

Last week we noted some improvement in Japanese government bond (JGB) flows. However, CAST flow shows a clear divergence from broader JPY flow (Exhibit #1), indicating greater investor interest in maintaining JPY liquidity.

Forward Look

The surge doesn’t necessarily mean that cross-border investors are outright purchasing JPY cash instruments. In the current environment, we believe it is a sign of risk aversion. The cash flows appear to co-move with the recent drop in Japanese equity holdings.

Consequently, this could be a sign that cross-border investors have liquidated their equity holdings but are not willing to repatriate for now. Instead, they are moving toward short-dated instruments that could be re-deployed effectively, whether into JGBs, Japanese equities, or even rolled, as rates may yet rise.

However, unwillingness to repatriate is not the same as adding to purchases and expecting the currency to return to fair value. More unhedged buying of JGBs would be a stronger signal of fiscal stabilization, but this week’s auctions suggest the market is still some distance from that outcome.

New Zealand: declines in non-resident NZGB holdings hitting NZD valuations

EXHIBIT #2: NON-RESIDENT NZGB HOLDINGS VS. NEW ZEALAND REER

_{Source: BNY, Reserve Bank of New Zealand, Bank for International Settlements}

Our take

The Reserve Bank of New Zealand (RBNZ) decision will be the only key G10 central bank decision next week, and easing is expected to continue. Although the Monetary Policy Committee continues to see both upside and downside risks to the inflation outlook, the domestic demand bias is clearly unfavorable. Wage growth is now running well below inflation while employment growth is also flatlining.

These trends point to lower non-tradables inflation, which is far more important to the overall inflation outlook than FX-impacted tradables prices. The prospect of additional easing, and rates falling to near-European levels, is clearly having an impact on valuations.

The New Zealand dollar’s (NZD) outlook in real terms continues to deteriorate due to New Zealand’s trade exposures, shifting expectations for the Reserve Bank of Australia, and the view that many Asia-Pacific currencies are considered undervalued. The latest Bank of International Settlements real effective exchange rate (REER) indices already point to the risk of NZD falling below 2022 lows.

Meanwhile, external interest in local assets is also weakening, as the prospect of “lower for longer” undermines the case for overseas flows into sovereign debt. The latest data indicate non-resident holdings in New Zealand government bonds (NZGB) are struggling to hold above 60%, though a retreat to below 50% – as seen in the first months of the COVID-19 pandemic – is unlikely.

Forward look

With clearer signs of inflation softening through the wage channel, the RBNZ, unlike the Bank of England or even the European Central Bank, can still cut rates without triggering stagflation fears.

The main concern is that even with additional monetary support, trend growth appears to have “de-rated.” Since the pandemic-era fiscal stimulus wore off, growth has struggled in real terms, culminating in a contraction in 2024, driven in part by fiscal consolidation, which also created the conditions for aggressive easing.

Headwinds from lower private and public sector demand are expected to ease over the medium term and support prices, but weaker demographics and productivity have become material constraints. We are particularly concerned about a cumulative 6pp drop in gross fixed capital formation between 2023 and 2025, which will likely generate an extended growth drag.

Persistently dovish policy is already weighing on inflows, but the prospect of renewed stagflation would further compromise asset allocation and NZD valuations.

ZAR holdings flatline as gold prices begin to hit holdings

EXHIBIT #3: ZAR AND EM EMEA METALS AND MINING (GICS LEVEL 3)

_Source: BNY

Our take

Even as it continues easing, the South African Reserve Bank’s (SARB) policy path is not expected to weigh on the currency itself. The shift in the inflation target to 3%, if achieved, continues to point to a healthy real-rate stance for the South African rand (ZAR). As the risks to the U.S. dollar and broader developed market monetary conditions tilt toward further easing, the ZAR is almost trading like a safe haven. It is currently the second-best performing currency against the dollar in Q3, after the Colombian peso (COP). iFlow also shows holdings resilience, and much of the rand’s current strength reflects South Africa’s domestic fundamentals.

However, we are also concerned that gold linkages are an underappreciated factor. While the terms of trade and balance of payments have improved and should be reflected in the ZAR, the local equity market may face some concentration risk, as South African mining stocks are viewed as a proxy for gold prices.

Until recently, EM EMEA metals and mining stocks (GICS level 3) were more than 40% above the rolling one-year average as gold prices surged through $4,000/oz. But a recent selloff shaved 10pp off that score and may now be undermining ZAR performance as well.

Given we have identified the ZAR as vulnerable to rebalancing for several months, a material correction in gold prices will likely have a knock-on effect on the currency and shape SARB’s policy path ahead.

Forward look

The link between commodity performance and producer currencies is tenuous at best. For example, the Chilean peso (CLP) remains soft, despite recent bond market inflows that are largely driven by politics – a dynamic also in play for Argentina.

Meanwhile, energy producers continue to struggle with terms of trade. Even the Norwegian krone (NOK), the best-held G10 currency, has adjusted from recent holdings highs.

Consequently, this year’s outlook for commodity FX hinges on asset inflows, either driven by real rates (e.g., South Africa, Norway and Colombia) or structural re-rating (Chile).

If key exports struggle to generate the requisite repricing in asset markets – as is the case in Indonesia and even Australia – currency performance could underwhelm. We continue to see the ZAR standing out for now due to heavy asset positioning and current performance, but being defensive, rather than outright bearish, remains the best approach. A rebound in gold remains possible if markets reprice U.S. and global monetary policy conditions.

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