Key Highlights

• Funders generally bid but the JPY is the clear exception
• European defense less confident in investment boom
• Outflows from high-yielding bonds driving FX hedge unwinding

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JPY now the clear outlier within funding currencies

EXHIBIT #1: WEEKLY SCORED FLOW VS. HOLDINGS, LOW-YIELDER/SURPLUS ECONOMIES

_{Source: BNY iFlow}

Our take

Risk appetite may have staged a light recovery through recent trading sessions, but there is generally no let-up in monthly safety flow into low-yielding funding currencies. CHF is now the strongest performing currency in all iFlow and a core beneficiary of risk aversion. Performance in spot speaks for itself, but the Swiss National Bank’s ongoing hesitancy to deploy negative rates has significantly reduced the risk of negative carry, which has helped drive a material recovery in holdings. However, we don’t see it moving into overheld, as valuations are not on its side, unlike APAC currencies. 

It is no surprise, then, that out of the major funders, the best-held are in APAC (TWD, SGD, JPY and KRW), and all have a case for valuation improvements. However, JPY is now a clear outlier: Over the past month, it has also been the most sold out of all these potential safety plays. This reflects ongoing concerns about the direction of fiscal and monetary policy, alongside emerging geopolitical risks that could also affect the economic outlook.

Forward look

The current holdings and flow divergence point to two distinct dimensions in the market’s approach to safety: smaller, savings-heavy currencies are expected to perform well as overseas investors hedge positions, especially if the Federal Reserve can push rates lower. 

Even with stretched valuations in currencies such as CHF and SEK, heavy current account surpluses support the case for ongoing currency appreciation – with the TWD being the most extreme case. Meanwhile, JPY, CNY and EUR are facing outflows. However, only the JPY is facing sales from an overheld position, which indicates a meaningful reassessment of its valuations narrative. 

Despite central bank caution, we continue to see gains for funding currencies in the current environment. The near-term risk is that JPY’s divergence from peers will widen until it reaches a significant underheld position or there is an abrupt change in Japan’s fiscal narrative.

Equities: European defense holdings halve as peace talks continue

EXHIBIT #2: MARKETS WHERE EQUITY HOLDINGS GAP VS. FIXED INCOME IS ABOVE 30PP AS SHARE OF ROLLING 12-MONTH AVERAGE

_{Source: BNY iFlow}

Our take

European defense stocks are under further pressure this week on clear signs that all sides are moving toward a peace deal in Ukraine.

Since the beginning of the year – especially in February, when the transatlantic security debate was at a low ebb – European defense stocks have surged. The move has been driven by the notion that Europe must achieve strategic autonomy and invest heavily in defense. This was further supported by constitutional adjustments in Germany, which significantly increased defense spending, and by the prospect of additional joint-European efforts down the line.

At its peak, this pushed developed Europe defense stocks – which had generally been outperforming the broader market – to a holdings level 60% above the rolling 12-month average. Since the summer, these holdings have come under greater strain, with an even bigger adjustment in recent weeks.

Questions around the efficacy and realized spending of investment plans aside, moves toward near-term conflict resolution have also impacted holdings. The view is that reduced need for defense spending following a peace agreement could lead to reprioritization of budget allocations.

Forward look

The situation remains fluid, but we stress that the industry (GICS L3) retains a holdings level of over 30% above the rolling 12-month average.

As with semiconductor names in the U.S., there is a comparable level of concentration risk among defense names in Europe. Further adjustments are possible. Currently, Capital Goods (GICS L3) in developed Europe, which contains defense, accounts for nearly 20% of all DM EMEA equity holdings. That is nearly equivalent to Banks and Pharma (GICS L2) combined.

We expect the relevant industry and industry groups to remain under pressure in the near term, which may increase pressure on the EU to boost investment, especially public sector-led growth, in other areas. The public sector aspect of European defense is a key differentiator compared with the AI narrative in the U.S. There is common consensus and funding already deployed to support defense, whereas AI initiatives are largely reliant on the private sector. U.S. officials have even gone so far as to rule out a “public bailout” for AI.

The European defense story of 2025 is unlikely to be repeated. However, this doesn’t mean holdings should fully mean-revert, as long as the political will to bolster defense, backed by public investment, remains intact.

High-yielder fixed income clearly struggling amid fiscal dominance fears

EXHIBIT #3: KEY HIGHER-YIELDER MONTHLY SMOOTHED FLOW

_{Source: BNY iFlow}

Our take

We did observe a brief surge in iFlow Carry recently but did not see it through the lens of strong interest in high-yielder currency purchases. Rather, in certain cases, such as the TRY, the flows may have reflected significant hedge unwinding as asset allocators exited EM duration positions.

Our data show a significant pickup in sales in Indonesia and South Africa and Türkiye over the last three weeks (Exhibit #3). By contrast, Latin America is holding up better for now.

Generally, high nominal and real rates have supported these assets throughout the year, and hopes that further Fed easing will help anchor flows and holdings into year end have also played a role. However, while the Fed’s outlook remains uncertain, it has been difficult for high-yielding sovereign debt markets to manage liquidity preference in the face of the equity sell-off. At certain points in recent weeks, there were signs of a correlated selloff across different asset classes. 

Forward look

High real- and nominal-yield EM debt has been one of the best-held macro assets this year, often without sufficient FX hedging.

The deterioration in sentiment appears to be contributing to outright sales rather than incremental hedging, even though the cost of hedging itself has begun to fall with more assertive easing cycles across emerging markets.

These markets, including Latin America and Central and Eastern Europe, continue to struggle with fiscal-monetary coordination. The broad retreat suggests expectations of worsening fiscal conditions, especially if weaker global growth causes accelerated easing and additional stimulus.

Even though such countries’ funding abilities domestically are much stronger than historical levels, fiscal dominance fears need to be reflected in yield curves. The fact that South Africa is facing similar flows – even as its inflation mandate is strengthened with a lower target – indicates that sentiment in EM duration remains fragile in the absence of more sustained growth drivers.

Consequently, the case for EM next year appears strongest in equities, while duration may struggle simply to avoid further holdings losses.

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