Investments, Weekly Market Outlook

Bond investors appear to have placed their faith in commodities exceptionalism, with many positing that the recent pick-up in U.S. default rates will defy historical trends and remain confined to that industry.

New research from Deutsche Bank AG pours cold water on that idea, arguing that there are already signs of contagion in junk-rated debt outside of the commodities space.

A look at previous peaks in default rates shows the potential for more pervasive corporate stress. While default rates were higher amongst particular sectors—such as telecoms in the early 2000s or financials during the 2008 crisis—the rate for junk bonds excluding these specialized industries also increased significantly.

Source: Deutsche Bank

“Default cycles of the past have never been about a single sector, or small group of sectors,” Oleg Melentyev and Daniel Sorid, Deutsche credit strategiests, said in the note. “Yes, cycles were always driven by concentrated distress but they always found their way to affect other areas of the market.”

The strategists highlight recent pressure in the retail sector, including the travails of Quicksilver Inc., American Apparel LLC, and Aeropostale Inc., as evidence that defaults have already taken place outside of the commodities realm.

While pervasively low interest rates around the world offer some hope to the exceptionalists, by potentially helping to ease corporate funding pressures and allowing companies to refinance their debt. The European Central Bank’s planned corporate debt-buying program has helped boost already hefty demand for corporate paper.

Still, Deutsche reckons that this time the debt cycle isn’t that different.

“A frequent argument is being made here how all problems are going to stay limited to commodity sector,” the analysts concluded. “Evidence like this, coupled with emerging credit pressures in retail and capital goods sectors, suggest a contained cycle to be a weak starting assumption.”

Investments, Weekly Market Outlook

A gauge of expected price swings in the euro rose last week by the most in more than a month after Federal Reserve officials indicated the rate trajectory will be data-dependent, spurring greater scrutiny of the next U.S. jobs report, Bloomberg strategist Vassilis Karamanis writes.

Minutes of the Federal Open Market Committee’s April meeting published on May 18 and comments from several Fed officials last week reinforced the central bank’s dependence on economic indicators. Meanwhile, euro-dollar two-week volatility rose 113 basis points to end the week at 8.50 percentage points, the biggest increase since the period through April 8.

The gauge climbed by up to 131 basis points on Thursday, as market participants reacted to the Fed minutes and as the tenor also started capturing the European Central Bank’s June 2 rate decision. It remains at the lower end of its 2016 range, with the year-to-date average currently at 9.51 percentage points. That leaves room for a further rise, possibly to test the May 3 high at 9.46 percentage points.

Two-week breakeven in euro-dollar traded on Friday at 158 dollar pips, while the premium in implied volatility over realized stood at 2.02 percentage points. A rise above 2.58 percentage points would mark the widest gap since March 9.

Euro sentiment versus the greenback, as seen in the two-week 25-delta risk reversal, hit 58 basis points in favor of euro calls over puts on Friday, the most bearish level since March 10. The risk reversal is a measure of market sentiment and positioning.

On Thursday, closing levels on the gauge indicated bearish euro bets reached the highest level in almost seven months.

Note: Vassilis Karamanis is an FX and rates strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.