The next shoe to drop in FX markets will reshuffle currency values in an unexpected way. Here's how TD Securities is trading it.

• The yen carry trade unwinding spooked markets as investors sold off positions to cover debt.
• The yen deleveraging has mostly played out, reducing the risk of further market impact.
• But a global growth slowdown could lead to further volatility in forex markets, TD Securities says.

The unwinding of the yen carry trade earlier this month spooked markets as investors sold off their positions, including in the US market, to cover their Japanese debt.

But from where we started a month ago to where we are now, the deleveraging of the yen has pretty much played out, says Jayati Bharadwaj, a global FX strategist at TD Securities. It may continue in the background, but an unwinding risk that could further trickle into the global market is much lower now, she said.

Still, currency traders should be on guard. Cooling global growth, continued geopolitical risks, and uncertainty around US election outcomes mean it could be a choppy ride for the next few months.

Also, it's still possible that other carry trades unwind, which happens when traders borrow in a currency with low interest rates to invest in a higher-rate one, and the latter moves sharply. Specifically, the Mexican peso could see a violent drop in value as the country takes on new leadership that could create uncertainty around central bank policies. Until now, peso investors have enjoyed interest rates ranging between 10.75% to 11%.

But carry unwinds are only one part of the story, and it's not where the real risk in FX markets is right now, says Bharadwaj. The next shoe to drop will be triggered by a slowdown of the global economy, which could reshuffle values in the currencies of the big global players, she noted.

"The biggest piece of the puzzle is the rest of the world's data," Bharadwaj said. "Right now, markets feel that the US is weak, but the rest of the world is still holding up, and that's why, at times, you've seen global equities markets rallying and holding up. I think if you start getting the rest of the world data coming in much weaker than expected, such that attention shifts from the US to the rest of the world, China, Europe, and the UK, markets will get really concerned about global growth."

In recent months, the International Monetary Fund has warned that the global economy's main growth engines, China and India, are set to slow over the next five years. The World Bank's deputy chief economist said that although global growth is stabilizing post-COVID, 60% of the world's economies will advance at a slower pace than their pre-pandemic average through 2026.

Below is an IMF chart showing projected output gaps by region. This measure of efficiency is based on the difference between a country's actual output and its output capacity, measured as a percentage of its potential GDP.

If global GDP — excluding the US— or survey data signals a slowdown is on the horizon, then the European currency market would be facing elevated risk. The euro at $1.11 and the pound at $1.31 versus the dollar are running hot and at their highest prices in over a year. Simply put, they're too optimistically priced, Bharadwaj noted. Meanwhile, the dollar's positioning relative to both currencies looks more neutral, she added.

Expectations of a weaker dollar have fueled bullish sentiment toward the euro and pound. As the Federal Reserve prepares to make its first round of interest rate cuts of this cycle, demand for the dollar would drop as investors hunt for returns elsewhere.

But if US economic data stabilizes while global growth slows, as Bharadwaj expects, European currencies could be set for a violent snapback.

The catalyst for such a correction would be either the next payroll report coming in softer than expected or September's FOMC meeting only bringing a 25-basis-point rate cut, which is TD Securities' benchmark view.

Bharadwaj told Business Insider that her team is positioned for euro weakness over the next three months and has slammed on an options trade that is short EURUSD via 1x1 put spreads.

"I do think that global growth right now is not holding up from our data trackers. Of course, the US is weakening, but the US is not falling off a cliff," Bharadwaj said. "And in fact, we actually track global growth upgrades versus downgrades. And after a very long time, global growth downgrades are outpacing global growth upgrades, which indicates to me that even the global growth is not as rosy as markets are currently pricing it to be."