Key Highlights

• APAC funders preferred as valuations drive holdings
• European defense sees second wind, but industrials remain under pressure
• Steepening risk returns across European government debt

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APAC funders’ holdings uniformly overheld for first time since 2021

EXHIBIT #1: MONTHLY SCORED HOLDINGS, CROSS-BORDER BASIS FOR SGD, KRW, TWD AND JPY

_{Source: BNY iFlow}

Our take

As global geopolitical tension remains at the forefront of market drivers, asset allocators are stepping up their search for havens. Gold and ‘real assets’ have dominated year-to-date gains, but long-standing concerns over broader physical demand remain, making further diversification necessary.

Even though iFlow’s FX holdings show high-yielding currencies are at their most-held in 18 months, the funding mix is now entirely different. For only the second time in the last five years, the surplus-heavy APAC currencies JPY, KRW, TWD and SGD are simultaneously overheld. The last time this occurred was in Q1 2021, when the world was first emerging from the pandemic and markets had scope to consider some degree of policy normalization.

Although spot price action in these currencies leaves much to be desired, and has even triggered a reaction from the U.S., there is growing realization that current valuations are extreme and unsustainable. The current move in holdings indicates that cross-border clients are materially reducing hedges to avoid being caught on the wrong side of a major adjustment in valuations, whether market-driven or not.

Forward look

APAC funding currencies have traditionally benefited from expectations of repatriation flows upon risk aversion. With high local savings levels, the notion of fiscal dominance had never really been in play – until recently. Current price action in the JGB market already points to concerns over fiscal credibility, a matter that even Finance Minister Satsuki Katayama has acknowledged.

Conversely, if credible fiscal policy drives growth – led by domestic consumption – and steepens curves, a strong case emerges for behavioral changes that will keep more savings onshore to fund growth rather than recycled abroad. Developments in the U.S. may also be contributing to such a view, though only on the fixed income side.

Marginal changes in these flows matter more than adjustments in hedge ratios by overseas investors. Finally, the CNY has not seen material gains in hedges, despite ongoing improvements in equity asset holdings. The direction of fixings and recent People’s Bank of China (PBoC) commentary also hint at comfort with currency strength. We do not expect a broad rush into APAC currencies, but a structural shift in holdings preferences by cross-border investors is underway.

Equities: European defense stocks at lower holdings base but value scarce elsewhere

EXHIBIT #2: SCORED HOLDINGS – DM EMEA DEFENSE, AUTOS (GICS L3) AND INDUSTRIALS (GICS L1)

_{Source: BNY iFlow, Bloomberg}

Our take

The market still appears to view a negotiated settlement over Greenland as the base case, but this does not preclude further European efforts to boost defense spending in pursuit of “strategic autonomy.” European asset holdings now begin from a very different base than at the start of 2025.

As a result, we do not expect a strong “amplification effect” in price action from recent news, unlike Q1 2025, when the first meeting between Presidents Zelenskyy and Trump drove significant volatility. Even so, European defense remains in focus for equity allocations, with strong reactions evident in recent sessions.

Despite a material drop in holdings – from 60% above the rolling 12-month average to around 15% – the sector remains materially overheld relative to peers. Still, the ongoing surge of flows into the sector underscores concentration risk in European equity allocations and weak prospects for other industries.

In our view, fiscal impulse will remain strong in Europe for strategic needs, but it is imperative that this produces a positive multiplier effect on broader economic competitiveness. Even U.S. Treasury Secretary Scott Bessent repeatedly cites the Draghi Report on European competitiveness when referencing structural concerns.

Forward look

Our equity holdings data show that the automotive sector in developed Europe has not been overheld for any sustained period since early 2024. Faced with rising competitiveness challenges from China, the broader industrial sector is also at risk. (This GICS L1 sector does not include the automotive industry.) Holdings sit only around 10% above the rolling one-year average.

In our view, a healthy rotation into Europe would rely less on defense remaining the best-held sector, and more on a broad-based improvement in industrials supported by stronger domestic demand. This was our expectation for European growth in 2025, and it remains our view going forward.

Even so, tariff risk suggests that further tightening in financial conditions, through real effective exchange rate appreciation, would be unwelcome for growth. A weaker EUR may need to be part of the rebalancing framework to support valuations.

Fixed Income: Fiscal, (geo)political and inflation concerns add to steepening risk

EXHIBIT #3: CHANGE IN SHORT UTILIZATION, EUROPEAN BONDS BY MATURITY

_{Source: BNY iFlow, Bloomberg}

Our take

Geopolitics aside, recent moves in Japanese equities have heightened scrutiny on global bond curves, particularly in a fixed income market with little tolerance for fiscal dominance. Once again, Europe is under the microscope for steepening risk, but we believe bond markets should be assessed on a case-by-case basis.

For example, iFlow data show that short utilization in German Bunds is already well above 2025 levels and has moved the most, signaling expectations for further steepening. The moves began toward the year end, driven by the European Central Bank’s pivot toward inflation risk, back-loaded fiscal impulse, and upward revisions to the growth outlook. Markets are likely to welcome these trends as a potential sign of stronger trend growth in Germany, especially if productivity improvements materialize. Furthermore, early signs of rapprochement with China on exports may also help ease downside price pressures.

In contrast, the largest absolute increase in short utilization from 2025 lows has occurred in French OATs. We have long highlighted that holdings in this market are materially weaker than in Germany or Italy – a clear sign of fiscal credibility risk. This week’s news that a budget will be passed without parliamentary consent has introduced domestic political risk into France. Although markets have become somewhat desensitized to such events, a defensive posture is likely to persist.

Meanwhile, improved real yields in the U.K., supported by a cautious Bank of England, encouraged strong local purchases in Q4 last year. The anticipated fiscal stress heading into the November budget did not play out.

Forward look

We do not see European fixed income demand shifting materially based on current events. Domestic demand remains a crucial anchor for performance, especially in real yields. Although the U.K.’s fiscal profile has been unfavorable, real yields have steadily improved along the long end of the curve, and the retreat by international investors has not been disruptive.

French inflation is now among the lowest in the Eurozone, which should help anchor demand. A strong euro will also help limit inflation pass-through risk, though that may change later in the year. High real yields are not cost-free, however, and will weigh on growth through tighter domestic financial conditions.

Still, the onus for European growth lies more with productivity and competitiveness gains, both of which require deeper structural reform. European bonds may be in a quasi-sweet spot, but policymakers must act quickly to accelerate reform.

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