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The market had the weekend to digest the news that in return for EUR 10 billion of bailout funds from the EU/ ECB and IMF, Cyprus has to raise the best part of EUR 6 billion from bank deposit levies. This has divided the analyst community into two camps: 1, those who think this deal will cause contagion and ultimately the end of the Eurozone, and 2, those who think the market is over-reacting and the Cyprus issue is fairly unique and more of a reaction by the Eurozone authorities to Cyprus's very low corporate tax rate and history of tolerating money laundering and lax financial regulation.
Regardless of whatever camp you sit in, the fact is that this move by the European authorities has increased the risk that future financial support from the European authorities for troubled Eurozone member states will be more bail-in than bail-out, which suggests that the sovereign crisis has changed direction. The details of Cyprus's financial support package were hammered out very early Saturday morning. They include:
1, A 6.75% levy on deposits under EUR 100k, and a 9.9% levy on deposits over EUR 100K,
2, A rise in the corporate tax rate to 12% from 10%
3, An overhaul of financial regulation and anti-money laundering regulation.
Right now everything hangs on the outcome of the Cypriot Parliamentary vote on the bailout package that started at 0930 GMT. The government is pushing for a yes vote, although it may change the levy slightly, so that larger deposit holders take more of the burden. Apparently EU/ ECB and IMF officials don't mind how the levy is administered as long as the total amount of funds raised from it remain at EUR 5.6BN. The rest of the EUR 1.4bn required will come from the sale of publically owned assets. The outcome of the vote is highly uncertain, with the ruling party only holding 28 of the 56 seats in parliament, and vocal opposition to the deal from some politicians in Cyprus. Added to that, the Cypriot Archbishop, who is widely respected in the country, has called for the deposit levy to be scrapped and for Cyprus to leave the Eurozone.
We expect a result sometime later today, although we would note that the vote has already been postponed once. If the Parliament votes yes, then fears about the sovereign crisis could calm down, but if it votes no then bankruptcy beckons.
Why such a muted market reaction so far?
The market reaction today has been fairly muted compared to other flare ups of the sovereign crisis. The euro has recovered and is back around 1.2950 after a 150 pip drop, Italian bond yields are lower on the day and although Spanish bond yields have risen, they are only back at early March 2013 levels. Stocks have taken the bulk of the pain, particularly the financial sector. The Eurostoxx index is 1.5% lower today, led lower by a 3% drop in financial stocks. However, even in this space the sell off is showing signs of bottoming. Spanish bank Santander fell nearly 4% at the Tokyo open, but has since started to recover.
So why the muted sell off? There are a couple of reasons: 1, the market could be waiting for the outcome of the Parliamentary vote and 2, the market may think that Cyprus is a one-off case. While there has been lots of debate about whether the same could happen in Italy and Spain, some may think that the stringent bailout conditions is a reaction to Cyprus' low corporate tax rates, which are up two thirds lower than elsewhere in the currency bloc, and also because of its history of money laundering. In the short term, all eyes are on the outcome of the parliamentary election, a no vote could cause a wave of risk aversion.
Cyprus sets the tone for future bail in-and-out
While we think that bail-ins will become the norm, especially if the "too big to bail" Spain and Italy need financial support in future, the difference with these countries is that 1, their banking sectors are significantly smaller as a % of GDP compared to Cyprus and 2, the ECB can step in to "do what it takes" to reduce stress in Italy and Spain. In contrast, Cyprus is beyond the help of the ECB alone as many of its banks can't meet the ECB's already low collateral rules that allow them access to cheap and unlimited funds.
The ultimate showdown: Russia vs. Germany
While the spill-over effects of the Cyprus bailout could cause a sell off as New York comes in later today, we think the bigger issue could be the potential show down between Russia and Germany. Many a conspiracy theorist could argue that Cyprus is merely a pawn in a larger battle between the EU and Russia. The Russian finance minister said the Kremlin was not consulted over the bank levy, and it may reconsider its participation in Cyprus' bailout after the weekend decision. Immediately after this, Germany's Green Party, who has been gaining political traction ahead of September's Federal elections, said that the bank levy was "basically right". There is a history of major disputes in Europe being triggered by small countries, thus Russian/ EU relations in the coming months are worth watching.
Elsewhere, there is a lot of fundamental risk this week - the FOMC meeting, the UK Budget and Eurozone PMI's. It's also worth remembering that Italy's political impasse could be brought back into focus in the next few days. The horse-trading begins to try and form a sustainable Italian government; if this fails to happen then another round of elections will be on the cards for later this year. All of this is important stuff; however, today the focus is squarely on Cyprus and its parliamentary vote.
One to Watch: Trading the Cyprus bail-in
As we said, in the short term there are two potential market outcomes from this: 1, a muted response on the back of a yes vote in today's Parliamentary debate, or 2, panic if Cyprus votes no and faces bankruptcy.
Here are our ones to watch:
1, "positive" outcome - yes vote: USDJPY continues to recover and moves back to the 96.60 highs from last week on the back of expectations of a more upbeat tone from the Fed at this Wednesday's meeting. Thus, any weakness in USDJPY is bought into. Good support lies at 94.50 -t he lows from earlier, and then 93.20 and 92.90, which could act as buying zones later this week.
2, Gold - the precious metal has traded like a safe haven today, as investors (maybe Cypriot and Russian ones) take their cash out of banks and put it into something deemed less likely to come under a levy from the troika. The yellow metal is above EUR 1,600 at the time of writing, and we think it could continue to extend gains if there is a no vote in Cyprus today. If Cyprus faces bankruptcy deposits could be wiped out altogether, causing mass panic and a rush for a currency alternative like gold.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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