Key Highlights

• ZAR hedging likely to continue, other high yielders selling to moderate
• JGBs and/or JPY should benefit from month-end recovery
• South Africa’s balance of payments set to show strong improvement

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Equity rebalancing: ZAR, CHF and CAD face sales risk

EXHIBIT #1: CURRENCY DIRECTIONAL FLOW ESTIMATE FOR EQUITY-BASED REBALANCING

_{Source: BNY, Bloomberg}

Our take

Given the event risk around the FOMC decision and the various summits and trade talks taking place in Asia, some month-end rebalancing flow was likely brought forward toward the end of last week. Regardless of the timing, market sentiment has erred toward risk-off throughout October, with commensurate FX flows in iFlow Carry turning statistically significant and negative during the second half of the month. Consequently, we would expect general rebalancing to err on the side of risk-on, or at least not point to further damaging flow for high-yielding currencies. However, as equity markets did not register extremely aggressive moves (iFlow Mood moved back to neutral in the final third of the month), the excess underperformance of risk assets that would normally require a positive offset did not apply.

Ultimately, we have only identified three currencies that may face significant equity-based rebalancing (Exhibit #1): ZAR, CHF and CAD. ZAR and CAD registered very strong marginal performance in equities. This is likely due to South Africa and Canada’s unique exposures to mining performance, as gold and rare earths/strategic metals are generating strong allocation interest, for different reasons. Even though ZAR was net sold through October, investors remain heavily overexposed; CAD was the second-best performing currency in flow terms in the first three weeks of October so rebalancing need is materializing on both the equity and FX leg. Furthermore, if the BoC leans toward caution due to renewed trade-based stress, CAD sales will face little resistance.

CHF’s rebalancing need is solely due to its strong performance in October, as it was the best-bought out of the fifteen currencies we track for rebalancing purposes. The currency will likely struggle the most if carry interest returns.

Forward look

With the Fed on course to cut rates further in the wake of the September CPI print, there is a “soft” case for gradual recovery in carry interest, but the best the market can hope for is non-escalation on the trade and geopolitical front. There is a similar story in macro terms, as most high-yielding currencies will continue to face central bank easing pressures, with rate cuts more likely as soon as some degree of currency stability is realized. Consequently, not only are there no net purchase signals for the likes MXN, BRL or INR, but further mean reversion beyond month-end rebalancing could just mean “less selling” of carry names rather than outright strong inflows.

Fixed income: Recovery in store for JPY after JGB selloff

EXHIBIT #2: CURRENCY DIRECTIONAL FLOW ESTIMATE FOR FIXED INCOME-BASED REBALANCING

_{Source: BNY, Bloomberg}

Our take

CHF and CAD also face a fixed-income rebalancing need for reasons similar to the equity signals: CHF due to strong purchases through October, while Canada was the third-best performing fixed income market we track – which indicates that expectations for the economy are increasingly cautious. It is quite telling that the recent rally in USDCAD has not resulted a renewed steepening of the Canadian curve (the 10y was already down more than 10bp through the first half of October), pointing to very limited pass-through effect. This suggests the market agrees with general central bank assessments that trade stress for exporters will remain net disinflationary, even if there is a currency decline. The NZD’s rebalancing need is purely due to strong fixed income performance, which is no surprise in the wake of the surprise RBNZ 50bp cut in early October.

The only rebalancing signal in favor of currency purchases in any asset class in October is the JPY (Exhibit #2). We have detailed how the JPY has sharply underperformed throughout the recent risk-off phase, being the only low-yielding APAC currency which was not net bought due to concerns over the BoJ’s rate hike prospects amid changes in government policy. Furthermore, Japan was also the weakest-performing bond government bond market among the majors, though admittedly the marginal decline was not strong. On a combined basis, however, strong JPY hedging and JGB selling does point to asset allocators being heavily underweight Japan exposures.

Forward look

Caution will likely prevail ahead of Thursday’s JGB decision to see if there is any changes in policy execution, but barring any significant changes which could push USDJPY into new ranges, on a tactical level there could be some scope for recovery flow into Japan. How this takes place is a different story: iFlow continues to show a significant overheld position in JPY (though much reduced after recent sales), while Japanese equities continue to perform strongly. We suspect the preference will be a continuation of equity performance in October, whereby inflows into equity markets continue but with slightly softer hedge ratios.

Asset allocation: Strongest recovery in South Africa in three years

EXHIBIT #3:  IFLOW EM LEADING INDICATOR FOR THE PORTFOLIO ACCOUNT (BALANCE OF PAYMENTS)

_{Source: BNY, Macrobond}

Our take

Of all tracked currencies, ZAR selling has been the most consistent rebalancing signal from iFlow over the past six months. However, strong real yields have helped the currency defy such pressures, while the market has attached very limited risk premia to domestic event risk and ongoing difficulties in its trade relationship with the U.S. Undoubtedly, the rally in gold has generated a major terms-of-trade boost and lifted inflows into both equity and bond markets. Consequently, our iFlow EM leading indicator (Exhibit #3) shows that on a rolling 12-month basis, asset flows have turned positive in South Africa for the first time since late 2021. This matches the direction for official figures (which have already turned positive) and further consolidation is likely.

Forward look

Due to the ZAR’s resilience in the face of rebalancing signals, we believe that the recovery flow into the country now looks structural in nature and would not fight the momentum. Recent interest has been equity driven, whereas traditionally the country has relied on much larger debt inflows to support its portfolio account. The fiscal narrative has not been promising in recent years, but with real yields continuing to support inflows, debt servicing costs may even start to decline and complement higher revenues associated with mining. We are not calling for a return to the situation a decade ago when the country regularly attracted more than $20bn in inflows on a rolling annual basis, but a re-rating must now be recognized, along with asset allocation implications. Our preference remains for higher hedge ratios as SARB cuts rates further, but asset flows will likely stay resilient.

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