Key Highlights

• FX carry now at clear risk of reversal
• APAC reaction reflects valuations as much as supply
• High-yield credit not excessively held, gap vs. equities may close

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Carry trades at risk from U.S. policy

EXHIBIT #1: IFLOW CARRY AND HOLDINGS

_{Source: BNY, Bloomberg}

Our take

Risk appetite will likely remain fragile throughout the current conflict in the Middle East. The most important factor affecting all asset classes is how financial conditions evolve. The speed at which policy expectations are changing is catching multiple areas of “long-risk” positioning off guard. Central banks will not overreact in the near term. However, with the  credibility of inflation targeting damaged in 2022 to 2023, there is little room to give inflation expectations the benefit of the doubt. Interest rate pricing for core central banks has shifted materially over the past 48 hours: hikes are back on the agenda for the European Central Bank, while only one full cut is left in pricing for the Federal Reserve and the Bank of England. In FX markets, this is directly reflected in a shift in the viability of carry trades.

Our data show that on a holdings basis, high-yielding currencies remain well held, but flow trends are clearly deteriorating and will likely push deeply into negative statistical significance soon. The crucial anchoring factor for any positioning remains real rates, but if inflation breakevens begin to move materially from a supply shock, these trades can also unwind very quickly due to excess positioning.

Forward look

Given geographical proximity and supply chain exposures, EMEA currencies are more at risk than LatAm peers in carry trades. RON will probably be the first high-yielder in the region to move back into underheld territory, but its real rate stress was present even before recent developments. Meanwhile, Hungary and Poland already had strong fiscal impulse in play, and a supply shock will exacerbate downside risk in the real rate outlook. A crucial test will come on Wednesday with the National Bank of Poland decision: Heading into the weekend, the market was heavily in favor of a cut. Now, an on-hold move seems prudent, and this could pave the way for further policy pivots across the region as larger real rate buffers are retained.

Equities: APAC semiconductor holdings stretched

EXHIBIT #2: DAILY SCORED HOLDINGS, EM APAC SEMICONDUCTORS (GICS® LEVEL 2) VS. GLOBAL EQUITIES

_{Source: BNY, Bloomberg}

Our take

The sharp move in South Korean equities and ongoing weakness in the KRW this week underscores energy supply risk for manufacturing-based APAC economies. The experience of 2022 to 2023 shows that trade surpluses and high savings buffers can be run down very quickly in the event of an energy supply shock. Efforts to diversify exposures have not accelerated in recent years in the region, while demand for semiconductors and other highly value-added manufacturing components have only increased energy needs for production purposes.

However, we believe the moves in regional assets also reflect excess positioning that may have extended beyond fundamentals. For example, the Semiconductor industry group (GICS® Level 2) is the best held EM APAC industry group, heading into recent events, with holdings 60% above the rolling one-year average (Exhibit #2). The gap versus global equity holdings has reached the highest levels in well over a year, and some convergence was always in the cards. We expect further selling until total and relative holdings moderate. Any margin pressures – regardless of the source – could cause an overshoot in the adjustment.

Forward look

EM APAC Semiconductors are at risk in the near term due to the industry group having strong alignment with the broader global AI theme. Even if capex is secular in nature and will generate strong productivity gains, the near-term tightening in financial conditions will attach a higher discount factor to such flows and require a valuation adjustment. However, we do not expect a repeat of 2022 to 2023, as the broader global demand cycle is very different. Furthermore, inflation in APAC, even during that period, never reached the highs in Europe and much of the Americas, as fiscal spending was far more constrained at the time. Even with a supply shock, we expect targeted efforts at resilience rather than blanket price guarantees or subsidies, which were prevalent elsewhere.

Fixed income: Credit gap over equities stable

EXHIBIT #3: DAILY SCORED HOLDINGS, U.S. HIGH-YIELD VS. U.S. EQUITIES

_Source: BNY 

Our take

Even before escalation in the Middle East tensions, concerns were growing over private credit, as markets were steadily re-pricing financial conditions in the U.S. due to more benign data. The sudden gains in inflation risk have only accelerated such fears, partly reflected by the moves in the U.S. financial sector. Listed credit could also face some strain. After having struggled in recent years due to high, risk-free nominal and real rates, credit performed strongly in the second half of 2025, as Fed expectations shifted and demand for spread products increased. Our data show that U.S. high-yield holdings recovered strongly in Q4, surpassing U.S. equities, and have retained that gap since. Although current holdings are not as extreme as some equity industry groups, the risk of adjustment is high due to the nature of the current shock.

Forward look

Financial conditions will remain the primary driver of credit performance. If markets view listed high-yield as having a slightly better risk profile on an aggregate basis than equities, we expect the holdings gap to stay in place. However, both asset classes will likely see holdings soften, and investment-grade will see a similar reaction. As in equities, the market will be more attentive to sectoral allocation in credit. If the current conflict is not prolonged and remains a short-term input cost concern, issuer stress should be more limited. However, if the impact is more extended and demands a broader policy reaction that once again raises risk-free real and nominal rates, performance could prove more problematic, especially if private markets – which are under greater scrutiny – create spillover effects. The worst-case scenario would once again see high-yield underperform equities in holdings in a declining market, which could point to a material drop in holdings value in addition to outright exposure reductions.

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