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Dollar, bonds…Why wild swings in stocks are next

The sharp moves in currencies and turmoil in government debt markets over recent days are likely to be followed by heightened volatility in major stock markets, according to one strategist.

"The reason I am concerned is not that valuations are a tad high or low, but that we have seen the unrest first in the currency market, then in the bond market and this will spill over into the equity market," Axel Merk, president and chief investment officer at Merk Investments, told CNBC Friday.

The euro has climbed almost 9 percent since hitting a 12-year low of around $1.0457 in mid-March, boosted by weaker U.S. economic data, a scaling back of expectations for the timing of a U.S. interest rate rise and a generally firmer tone to euro zone economic data.

The past month, meanwhile, has seen heavy selling in bond markets that has pushed yields sharply higher. Germany's 10-year Bund yield has risen a hefty 59 basis points from a record low of 0.05 percent last month, and the 10-year U.S. Treasury yield this week hit its highest level since December.

Traders work on the floor of the New York Stock Exchange.
Getty Images
Traders work on the floor of the New York Stock Exchange.

Analysts said a few things have contributed to the rise in yields: a rise in inflation expectations, especially as oil prices rebound, and an uneasiness with record low bond yields.

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Merk said that the catalyst for a sharp sell-off in equities was likely to be a change in monetary policy from the Federal Reserve. The danger, he said, was that the stock market suffered the same fate as the bond market, where investors piled heavily into one trade only to be forced to reverse those trades quickly once sentiment changed.

Watch out

"The one trade that's been working is momentum -- in recent years if you're a trader you've made money. It doesn't matter what the fundamentals are because if everyone else out there is buying it, you buy it too. It works until it doesn't. The best example of this is the German Bunds – everyone piled into that thinking, 'what can possibly go wrong if the ECB buys?,'" Merk said.

In March, the European Central Bank launched a 1-trillion-euro ($1.13 trillion) bond-buying program to stimulate inflation and economic growth in the euro area. In theory, quantitative easing puts downward pressure on yields, but in recent weeks German yields have risen sharply as investors' perceptions about inflation changed, forcing many traders in turn to question whether lower yields were a one-way bet.

In contrast to the sell-off in the U.S. dollar and bond markets, the S&P 500, a broad measure of U.S. stocks, set a new closing record on Thursday on the back of weakness in the greenback.

Unstoppable?

"The only thing that could scare this rally in stocks right now is if selling in the 10-year and 30-year (Treasurys) accelerates to the downside and alongside that happening you start to see the dollar strengthening," Anthony Crudele, founder of EminiExchange, told CNBC.

"That combination would spook stocks, but other than that stocks look like they will continue to be bid."

In fact, a bull run in stocks -- European and Japanese stocks have gained over 10 percent each so far this year-- has fueled talk about whether equity markets have raced up too far, too soon.

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Peter Toogood, investment director at City Financial Investment Company, told CNBC on Friday that stock markets would continue to rally until June, when they would face a "reassessment."

"These markets are going up from January to June and then there will be a reassessment," he said. "Markets can run (higher) because of liquidity, but they are, in the case of the U.S., very expensive."

Merk added: "Sure enough something can go wrong and when things reverse, liquidity evaporates. That can happen anywhere. I warned about it in the currency market, I warned about it in the bond market, and now people still don't believe it about the equity market - but it will come."