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The 'bubble you're not watching' that could spell market trouble

Briefing highlights

  • The bubble markets are ignoring
  • Markets at a glance: Calm after a story
  • U.S. inflation higher than expected
  • U.S. retail sales slip
  • B.C. sparks home price gains
  • Japan in longest growth streak since 1980s
  • Canopy growth revenue on the rise
  • Teck sees big demand for steel-making coal

There's a bubble out there that markets are ignoring, and that Bipan Rai fears could soon be an issue.

Mr. Rai, executive director of macro strategy at CIBC World Markets, sees problems brewing in German bunds, sovereign bonds that are similar to U.S. treasuries.

In a report on the recent stock market turmoil, Mr. Rai agreed with other observers that what happened last week was "a corrective move." Still, he's worried because many market players and the media all believe the same thing, that what took place wasn't worse than a "healthy" correction.

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"Additionally, there's still plenty of ambivalence and ambiguity about what the underlying drivers of the move are," Mr. Rai said. "Consensus thinking without confidence on the underlying circumstances should make everyone a bit nervous."

To recap, the rout was sparked by a U.S. jobs report that highlighted strong growth in wages, suggesting inflationary pressure that could force the Federal Reserve to raise interest rates up to four times this year.

Bond yields spiked and stocks plunged as, among other things, investors wondered whether bonds could become more attractive than equities.

Here's where German bunds come in.

In a report on "the bubble you're not watching," Mr. Rai cited the fact that many bunds now carry yields below the European Central Bank's deposit rate, one of its key interest rates.

"We're working with a theory of our own: that the recent swoon in stocks is in part being driven by the fixed income market - in particular, the steepening of the German 2-10s curve," Mr. Rai said, referring to two-year to 10-year bunds.

"This curve has been steepening very aggressively since the year started, which matters given that we estimate 30 per cent of the outstanding sovereign German bunds have yields below the deposit rate, and there are obvious convexity risks."

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Here's what he was talking about:

Mr. Rai also cited the fact that markets expect the ECB to further pull back on buying assets in a "tapering" of what's known as quantitative easing, or QE, a stimulus program that the monetary union's central bank has had in place.

"Expectations of further tapering from the ECB have clearly impacted asset prices (such as the EUR) and we'd suggest that this has had far greater ramifications for the markets," he said, referring to the euro by its symbol.

"Additionally, there's also the convergence story as other central banks are expected to follow and tighten policy in the years ahead," he added.

"The downside to this is that higher rates will make stocks look rich, but the market doesn't necessarily have to wait before selling equities. So, why a steepening and not a flattening if this is ECB-driven? The best rationale we can come up with to answer that is that the market is still pricing in little change to the deposit rate until early next year. Also, inflation pressures are clearly on the rise, which supports the steepening rather than flattening theme for now."

Bond prices that are too rich mean yields are too low, Mr. Rai added in an interview, noting the high demand for bunds because they're attractive, safe and a favourite of the ECB bond-buying scheme. Thus, the price spike.

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That's not sustainable over the longer term, he said, noting that the ECB is growing more "hawkish" and looking toward the end of its QE program.

The implications?

"I do think there will be a reckoning at some point, but it's a story to monitor later in the year," Mr. Rai said.

"The immediate implication will likely be a risk-off tone to global equities before things stabilize and we see gradual outflows for U.S. assets and inflows for European assets. This will provide further support for the EUR against the U.S. dollar."

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Markets at a glance

Global markets and the Canadian dollar settled down after some upset sparked by two key U.S. economic reports.

This came after government reports pegged U.S. annual inflation at 2.1 per cent in January, and retail sales down 0.3 per cent.

"It's Valentine's Day, but there was little to love about the combination of an upside surprise in U.S. inflation and disappointing growth for retailers," said CIBC chief economist Avery Shenfeld.

Fears that inflationary pressures will prompt the Federal Reserve to raise interest rates up to four times this year were behind last week's market selloff.

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B.C. sparks home price gains

Canada's housing market saw prices rise on a national basis in January, but the growth was almost entirely due to strength in Vancouver and Victoria, The Globe and Mail's Janet McFarland reports.

The Teranet-National Bank National Composite House Price Index, which measures sale prices in 11 major markets, rose 0.3 per cent in January over December.

Teranet said the price bounce was not widespread, however, with only four markets climbing in January, and prices buoyed largely by a 1.2-per-cent increase in Vancouver's market – which came on the heels of a 1.3-per-cent increase in December – and a 1-per-cent price increase in Victoria.

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