Stress in Credit Default Swaps?

MACRO FRAME

September’s CPI and PPI data continue to fuel expectations of a new hiking cycle from the Fed, while higher interest rates are adding to stress in credit markets.

STOCK INDEX FUTURES

Equity index futures were mixed overnight, tech weighed on the S&P and Nasdaq while the Dow gained. Credit default swaps related to AI companies have reflected their highest cost to insure against tech defaults. LSEG data showed five-year credit default swap spreads at Oracle were quoted at 288 bps on Thursday, up from 260 bps a week earlier. Five-year spreads for SoftBank widened by 24 bps to 424 bps, while CoreWeave’s CDS risen beyond 1,000 bps. Inflation and higher interest rates are compounding the negative effects on credit stress, adding to concerns about how much revenue these companies can bring in to cool fears.

September’s inflation data raises the hurdle for equities. While most of the headline figure (+0.6% m/m) was attributed to a rise in energy prices, the pickup in core prices and more specifically core services prices furthers the case for tighter monetary policy. Services excluding energy rose 0.4%, while transportation services increased 0.6%. Meanwhile, geopolitical risks in the Gulf risk oil and diesel prices moving further upwards despite President Trump’s efforts to cushion prices. So far, Houthi attacks on Saudi Arabian energy infrastructure have been modest, likely reflecting an active decision from the group that surging oil prices could put them in the crosshairs of the US military.

Given that the path of least resistance to the rates environment appears upwards, support for equities increasingly relies on strong earnings support. Bank of America’s October fund-manager survey found that 37% of respondents would consider shifting from stocks to bonds at a 6% 10-year Treasury yield, with another 22% requiring 6.5% or higher. Meanwhile, Barclays estimates that semiconductor names, who despite only accounting for 19% of the S&P 500’s weight, make up 35% of expected aggregate earnings growth this year. That leaves the index unusually dependent on the continuation of strong semiconductor earnings and the capital-spending cycle supporting them, both of which face downside risks in the event that higher yields will slowdown spending and thus demand. However, voracious demand for chips and memory supply across the AI infrastructure build out has shown a disregard to higher rates, which could underpin earnings growth and keep the indexes broadly resilient to a higher rates environment. Still, over the longer-term the market should not discount the risk of strong interest-rate headwinds.

Watch point: Despite tech volatility, the earnings backdrop suggests bullishness, despite the advent of a new hiking cycle.

CURRENCIES

US DOLLAR: The USD index fell 0.45% to 102.09. The drop in Treasury yields alongside the markets pullback from overdone Fed hiking expectations are weighing on the currency despite strong PPI and retail sales data. Producer prices in the surged 1.3% m/m in September, which is the sharpest monthly increase since March 2022. Core PPI rose 0.7%. Retail sales grew 0.8% m/m, thanks in part to the rise in gas prices. Excluding gas prices sales rose only 0.2%. The dollar index looks to be finding strong resistance at the 102.50 level. Money markets assign a 29% probability of a hike this month, compared with 20% before September’s inflation data.

Watch point: While current fiscal, macro, and geopolitical factors favor the dollar, it is beginning to enter overbought territory and could be susceptible to a modest correction.

EURO: The euro rose 0.50% to $1.1211, recovering from its Monday’s 17-month low of $1.11525, as French CPI data came in above forecasts while traders took profits in the dollar. Inflation rate in France rose to 3.1% y/y in September, revised up from the preliminary estimate of 3.0%, driven by a sharp rise in energy inflation to 21.3% from 16.7%. ECB President Lagarde said energy-driven inflation had yet to spread across the broader euro-area economy; ECB policymaker Šimkus warned that further rate hikes could be necessary as price pressures continue to build, adding that an increase as early as this month remained possible. Any slowing of its tightening cycle could further weaken the euro’s relative rate support.

Watch point: French sovereign stress will continue to be a dominant factor in price direction, however, the $1.10 level acts as a strong resistance level.

BRITISH POUND: Sterling is 0.40% higher against the dollar at $1.3244 following a raft of better-than-expected UK data. The Office for National Statistics said GDP in the UK rose 0.1% in August, as the AI-related tech sector contributed to growth. Consensus forecasts had expected a 0.1% drop. Still, there may be some more headwinds for the economy further into the year as higher energy prices eat into household incomes and spending. Elsewhere, finance minister Healey said Britain’s new budget would include measures to counter the energy price shock and reiterated that the budget will meet fiscal rules.

JAPANESE YEN: The yen rose 0.26% to 157.93 yen per dollar. Finance Minister Katayama reiterated warnings of government intervene in the currency market; she also emphasized that Washington and Tokyo’s remain in coordination following their joint intervention in July. Bank of Japan board member Koeda cautioned against restraint in raising rates, implying that the central bank could remain on track for further rate increases in the coming months. Earlier reports indicated that the BOJ was hesitant to implement an unusual back-to-back rate hike this month, while still considering a potential increase in December. Markets now price 18 bps of tightening be year-end. The currency remains under pressure from US rate differentials and a market that is unconvinced the central bank will raise rates in a timely manner. The greatest near-term upside risk for the currency remains market intervention.

Watch point: While markets are underwhelmed at the BOJ, a path for additional rate hikes looks to be  appears to be the primary scenario.

AUSTRALIAN DOLLAR: The Aussie fell 1% to $0.6900. A soft jobs report overnight is weighing on the currency. employment fell 39,300 in September, the largest in a year and expectations of a rise of 20,000. The unemployment rate held at 4.7%. Market expectations of a November hike have been pared from 32% to 9% following the data, while a move in December now priced at 28% from an earlier 56%. The drop in labor market conditions should give the RBA some more confidence that policy settings are adequately restrictive.

Watch point: August’s hiring figures argue for a higher-for-longer stance, leading the focus to Q3’s inflation data.

TREASURY FUTURES

Yields moved lower across the curve in a flattening move despite strong PPI data. Core PPI rose 0.7% m/m, while the headline figure rose to 6.3% y/y, its highest level in nearly four years. Mainly, the drop in yields reflects a market that had already been pricing hot inflation data and a Fed that is expected to hike multiple times over the coming months. More or less, the market bought the rumor and sold the news. Market pricing for an October Fed rate hike rose sharply to 50% on the back of the CPI data, before falling back to 29% as Fed officials reiterated that the central bank would continue to assess incoming data. Worries about AI companies’ heavy debt burdens are also fueling flows into Treasuries today. September’s inflation data represents a two-layered inflation problem: higher energy costs and firmer services prices that are complicating disinflation. Energy prices rose 5.2% in September and 20.4% over the year, while core CPI increased 2.6% y/y, up from 2.4% in August. While food prices were unchanged and several categories saw declines, increases recreation, education, airfares, used vehicles, and selected medical services add into the hawk’s camp at the Fed.

Watch point: Inflation risk, fiscal and corporate supply, capital competition and term premium will be key factors in determining whether the yield curve maintains its recent flattening or falls into a bear steeping move.

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