Key Highlights

• FX carry interest now showing general weakness.
• Food price inflation will increasingly feature in policy and asset allocation.
• APAC front-end flows remain tentative despite hawkish rate surprises.

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FX: ZAR aside, carry interest has all but vanished

EXHIBIT #1: WEEKLY SMOOTHED FLOW VS. HOLDINGS, G10 AND EM CARRY CURRENCIES

_Source: BNY

Our take

Risk sentiment remains contingent on a U.S.–Iran ceasefire agreement. The past weekend was another case of high expectations not being met. Equities continue to find support in energy and secular themes, but other asset classes are no longer benefiting from ceasefire talks or the prospect of a settlement. Rising inflation expectations, and what they mean for rate cuts, are weighing on bond markets. Yet, even as central banks lean hawkish, FX carry trades are not seeing any benefit. Our data indicate that cross-border flows into carry currencies are now highly defensive (Exhibit 1). Overheld currencies are seeing almost no inflows, and selling volumes have increased. Meanwhile, underheld currencies are struggling even where central banks – including the Reserve Bank of Australia and Bank Indonesia – have turned hawkish. The ZAR is the only outlier, as the South African Reserve Bank stands to hike this week, but performance thereafter will depend on external factors.

Forward look

Repriced Fed expectations are clearly the biggest driver of the shift. Markets are now pricing a full 25bp move by year end – a reversal from the expectation that Fed Chair Kevin Warsh would ease financial conditions upon taking office. U.S. inflation figures have moved beyond levels that can justify a dovish trajectory. Even so, the bar for an outright hike remains high, which may explain why broad-based selling of FX carry has not materialized. The dollar has unwound the hedging flows that built up before the conflict, but reverting to carry status is a qualitatively different step. Until the Fed signals clearly in that direction, we expect FX carry to remain broadly held, though profit-taking will dominate when valuation opportunities arise.

Equities: Supply strains drive surge flows into EM food producers

EXHIBIT #2: WEEKLY SMOOTHED FLOW IN DM AND EM EQUITIES, FOOD PRODUCTS (GICS LEVEL 3)

_{Source: BNY}

Our take

Even if a settlement is reached – and the Strait of Hormuz reopens – certain supply challenges will continue to affect global headline inflation through the rest of the year. The implications for policymaking and asset allocation are substantial. Food prices are moving swiftly up the agenda: According to the Center for Strategic and International Studies, 20%–30% of global fertilizer exports transited the Strait of Hormuz prior to the conflict. The region also produces significant amounts of energy byproducts used in fertilizer production elsewhere, all of which transit the Strait of Hormuz. Climate pressures in the coming months are also expected to raise food production costs, with knock-on effects on supply and final prices. In its rate hike last month, the Philippine central bank noted that “higher global oil and fertilizer prices have begun feeding through to domestic fuel and food prices.” We expect to hear similar statements across EM, where food insecurity is more acute.

Forward look

The conflict has mostly generated positive terms of trade shocks for “geographically unexposed” energy exporters, but we expect food and soft commodities to begin performing as well. For economies such as Australia and Brazil, whose export baskets comprise both groups, industrial commodities and energy will drive the bulk of adjustment. Strong market performance in economies such as Argentina also indicates that soft commodities can drive marginal flows. On a GICS Level 3 (industry) basis, flows into EM food companies are now at their strongest in nearly three months, and momentum is building for developed market peers. If global inflation continues to pick up, the staples sector is expected to benefit in a defensive sense. That said, the risk of government intervention is high – see the recent U.K. initiative asking supermarkets for voluntary price caps – and margin expansion should not be assumed.

Fixed Income: APAC hikes may be the norm, but front-end flows lag

EXHIBIT #3: FLOWS INTO APAC FIXED INCOME, <1Y AND 1-3Y

_Source: BNY 

Our take

Sri Lanka’s central bank decision rarely commands much attention, but yesterday’s 100bp hike to 8.75% (vs. expectations of 50bp) marks another hawkish surprise in South and Southeast Asia – a region grappling with supply pressures and weakening currencies. The country has suffered severe balance-of-payments challenges in the past, and the central bank is clearly seeking to shore up flows without expending limited reserves. The entire region remains highly dependent on Middle East energy imports, and pressure continues to build on import costs as reopening the Strait of Hormuz remains elusive in the near term, if not longer. Based on recent decisions and the current pressure on holdings (Exhibit 1), APAC is clearly leading the way in generating hawkish central bank surprises. North Asia’s larger strategic reserves and FX coverage give it more buffer against severe stress. However, whether directly attributable to the conflict or not, the financial accounts of South Korea, Taiwan and Japan are also under pressure. Coupled with headline price risks from food (Exhibit 2) and other imported primary goods, central banks may need to move more aggressively to help stabilize currencies. The Bank of Japan is expected to lead the way.

Forward look

The recent round of hawkish surprises in APAC has not helped the carry trade materially. Currency pressures aside, front-end flows into APAC fixed income have not been strong (Exhibit 3). The sub-1y part of the curve – the segment most closely tied to liquidity preference, as in carry trades – has been negative on a weekly smoothed basis since early April and shows no sign of reversal. Meanwhile, flows into the 1y-3y part of the curve have turned positive, reaching their strongest weekly smoothed levels since mid-March. Even so, it will take several more weeks to offset the selling that has accumulated since the conflict began.

With U.S. rate expectations also shifting higher, APAC will likely continue to struggle in front-end fixed income: IDR and INR offer yield potential but are weighed down by balance-of-payments stress. For larger, savings-heavy North Asia economies, higher import bills are weighing on FX performance, while policymakers remain reluctant to raise rates: China’s medium-term lending rate has fallen to a new low despite an evident shift toward PPI- and CPI-driven inflation. With such a policy stance and ongoing export and competitiveness challenges, there is little incentive for People’s Bank of China peers to move assertively on rates and risk a major policy gap.

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