BNY Mellon iFlow Carry Index at Record Highs: Is a Reversal Coming?

BNY Mellon says its iFlow Carry Index is at record highs, reflecting investors shifting to higher-yielding currencies as safe-haven plays diminish in importance, however the bank’s head of markets strategy and insights, Bob Savage, warns in a research piece that the driver does not last long and is “useful as an indicator for sharp reversals in risk assets across markets”.

Savage writes that the “reality of a hawkish pause from the Fed last week” confirms the risk of more tightening and “leaves open the risk of a summer of discontent” following March’s “dash for cash” during the US banking crisis. “Any sharp reversal in positioning could drive volatility higher from multi-year lows,” Savage writes, adding, “For FX flows, the start of summer is full of potential for reversals in risk assets as the carry trade reaches a record 20-year high – an unwind could wreak havoc.
“There is a significant difference between selling positions and adding less to one” he continues. “This seems the case with the iFlow Carry index at present. Its history of being in “extremes” – defined by over 0.25 – is notable in that reversals usually occur within a week.”

The research note observes that the longest period of the Carry Index being “extreme” lasted 83 days – which could be the entire summer ahead. “Buying less high-yielders has significantly less urgency than selling more of a position,” it states. “This may be a key factor in how the current FX driver unwinds as markets progress in waiting for more data, rather than reacting fearfully to unexpected events.

“The risk of a reversal may be more about how the higher interest-rate policies of Europe, the US and the UK play out in financial conditions,” it adds. “Historically, that lag in conditions to the real economy has been nine months on average, but it can extend far longer; 18 months is within the two-standard deviation bounds.”

Citing the usual candidates for the carry trade selling leg, CHF and JPY, Savage observes that the CHF trade is inter-linked with the fall of Credit Suisse, while the yen play is largely driven by recently-appointed Bank of Japan governor Ueda, not shifting rate policy as some expected. Noting that the CHF is at extreme levels and that the SNB policy-shift risk and the safe-haven correlation to rates remain in play, Savage writes, “The obvious point is that “safe-haven” holdings could be the vulnerable leg of any summer carry trade unwinding.”

On the other side of the trade, Brazil and Mexico continue to attract flows, MXN is now the most extreme holding in the iFlow FX universe, although more so the latter than former, in spite of a strong performance by Brazilian assets over the past month. With rate decisions by both central banks hinting at dovishness or an end to the hiking cycle, Savage warns, “As we face the seasonal summer slowdown of flows, the potential for a painful adjustment for carry trades may not yet be fully grasped, as less buying may be driving further rate pressures and become more linked back to central bank policy than is presently understood.”