Key Highlights

• JPY missing out on risk-off as Takaichi takes the reins
• EMEA equity hints at higher hedge ratios
• Latin America FI and FX struggling with total exposure reduction

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FX: Strong recovery in APAC funders skipping JPY

EXHIBIT #1: APAC FUNDERS WEEKLY SCORED FLOW VS. CURRENT HOLDINGS

_Source: BNY

Our take

Carry unwinding is clearly the main theme at present as asset allocators find it increasingly difficult to remain comprehensively “risk-on” through year-end. Geopolitical and economic stress, coupled with the U.S. data vacuum, have already driven outperformance across government bond curves, and the only surprise is that it took so long for FX to reflect such fears. High-yielding currencies are clearly under strain, but what is unique about the current round of carry unwinding is the heavy participation of low-yielding APAC names, in addition to traditional safety plays such as the USD and CHF. The market clearly favors high-surplus or savings economies in a debt-stressed environment, and it has been well-established that APAC markets remain far less dependent on foreign outflows compared to previous decades, so they are well-positioned to maintain resilience amid risk-off. In hindsight, current price action also suggests that they were actively used as funding currencies as well.

Forward look

We expect APAC FX top continue performing well, but there is one important exception. Of the seven currencies in the region with low yields and good surpluses, the JPY and CNY are currently being net sold on a weekly basis (Exhibit #1), but the selling in the JPY is particularly strong. We had identified heavy initial holdings as a vulnerability, but this doesn’t seem to be affecting KRW, which is now even better-held than the JPY and continues to enjoy ample inflows. Meanwhile, the CNY had faced some sales, but the latest daily figures indicate some recovery. Only with the JPY have outflows been extremely consistent, and the timing corresponds to new Japanese Prime Minister Takaichi’s election as LDP leader. The appointment of Satsuki Kata as finance minister is still being absorbed by markets, but her initial unwillingness to comment on financial assets and monetary policy points to a cautious approach. If the market moves toward full-blown risk-on driven by global factors, it is hard to see JPY under-performing as repatriation flows will dominate other factors. However, in the near term the currency is facing a higher “policy premia,” which the government needs to address in short order. If the JPY is struggling now and markets move back toward a risk-on environment in which APAC funders struggle again, JPY could face severe valuation challenges.

Equities: Surprising strength in EMEA equities hints at hedging rather than FX unwind

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

_Source: BNY

Our take

EMEA currencies continue to lead the carry unwind and we doubt performance will pick up anytime soon. Aside from strong anchoring of real rates, there isn’t any additional marginal information to price into Central and Eastern European FX performance. Another global favorite – South Africa – is facing renewed domestic headwinds, though in fairness the Government of National Unity has managed to navigate similar episodes in the past and the current terms of trade boost from gold prices will be difficult to offset. Consequently, even though HUF, ZAR and other EMEA names are being net sold, we are sympathetic to the view that, rather than FX-specific carry trades being unwound, this may reflect additional hedging on underlying assets, which continue to perform well in the region. We note that EMEA equity flow has accelerated strongly over the past few weeks even as global risk sentiment has been soft. On a weekly smoothed basis, the region’s equity flow could reach the highest levels in almost three months. FX performance, in contrast, is now at its weakest point in the last three months.

Forward look

Based on current equity inflows into the region and matching them against FX timing, it is likely that the new round of equity interest is being accompanied by greater hedging interest, whereas prior equity investment came from such a low holdings and valuations base that the market was willing to have much lower hedge ratios during the process. Consequently, prudence is clearly required for asset allocators, but renewed easing in the region is also making hedging more cost-efficient. We are more concerned about the macroeconomic outlook. CEE will face greater headwinds if core European growth weakens again as some of the PMIs indicate, and central banks will need to cut more aggressively to provide some easing. Holdings in Turkey have already adjusted adversely across all asset classes, which leaves South Africa quite exposed – our rebalancing analysis indicated that ZAR hedging was long overdue because of strong equity and fixed interest, and this could pick up significantly in Q4.

Fixed income: Sharp drop in local bond interest but FX also struggling

EXHIBIT #3:  WEEKLY SMOOTHED FLOW, LATIN AMERICA FIXED INCOME VS. FX

_Source: BNY

Our take

Another region where carry trades in both FX and fixed income looks exposed is Latin America. High nominal and real yields have anchored demand throughout the year, but our flows indicate that September was a particularly strong month for the region – buoyed by the news out of Argentina to complement carry demand due to Fed easing. In hindsight, the Latin America fixed income trade was running on fumes, especially as FX exposures were relatively high, and we seeing clear risks of a holdings correction. Current flow momentum points to sales matching the strength seen over the summer when the Fed was still seen in a “higher for longer” phase (Exhibit #3). This won’t be the case for now as the Fed’s risks are to the dovish side, but a softer U.S. economy will not benefit Latin American growth either. Central banks will continue ease, and idiosyncratic factors in countries’ bilateral relations in the U.S. will also affect positioning.

Forward look

Brazil and Colombia face the most difficulties with U.S. trade at present and we are seeing hedging interest reflected in their currencies. However, this isn’t the same for other countries such as Peru, where alignments look set to change. Current flow trends do not point to hedge unwinding either. If bonds are being sold but without much change in FX exposures, then mathematically hedge ratios should be relatively higher. We note that the strongest period of FX outflows took place toward the end of September, so the more recent round of carry unwinding has been shifted toward EMEA instead. As long as real rate buffers hold and bilateral talks with the U.S. are amenable, we don’t foresee disruptive moves in Latin American duration, but FX exposures will continue to struggle until carry unwinding hits extremes.

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