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Euro Won’t Find Calm Just Because Cyprus Hasn’t Collapsed...

By , Chief Currency Strategist
29 March 2013 22:51 GMT
Euro_Wont_Find_Calm_Just_Because_Cyprus_Hasnt_Collapsed_body_Picture_1.png, Euro Won't Find Calm Just Because Cyprus Hasn't Collapsed...

Euro Won’t Find Calm Just Because Cyprus Hasn’t Collapsed...

Fundamental Forecast for Euro: Bearish

  • Cyprus shutters a major bank, introduces capital controls and receives a bailout
  • Eurogroup Head Dijsselbloem suggests bank levies can be used in the future
  • EURUSD has fallen 7 of the last 8 weeks, will we return to 1.2675?

The Euro has been seriously fundamentally shaken these past few trading weeks as the Cyprus crisis unfolded. Now with harsh capital controls implemented and an imminent financial collapse (or Euro member exit) adverted, some industrious traders expect the shared currency to immediately recover lost ground. Such opportunistic optimism may be a little hasty however. The situation with Cyprus piqued investors’ fears specifically because of the damage it could do to the region’s monetary and financial unity – the foundation for maintaining a common currency. While the country is operational, an aura of fear remains. And, there are new, great problems on the horizon.

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First, it is important to appreciate what lasting stain the Cyprus situation has left on the Euro’s fundamental future. The fifth country to ask for an official rescue (Spain was number four, but its bailout was directly for the banking sector), there are still items that need to be ironed out. The €10 billion in aid that was promised by the Troika in exchange for the government’s ability raise approximately €5.8 billion of its own and shrink its banking sector has yet to be paid out as we await an official assessment. There is still a measurable risk that the country could still leave the Eurozone on further complications – a risk noted by Moody’s – but the immediate euro risk is evolving elsewhere.

With few avenues to raise the level of capital necessary to meet the Troika’s requirements for aid assistance, Cyprus took the unprecedented step of introducing a ‘bank levy’ on uninsured deposits above €100,000 held at the country’s largest lenders. This is a move approved both domestically and by Eurozone officials. In case anyone missed serious implications in this move, Eurogroup President Dijsselbloem made sure to state it clearly: future bailout requests can follow a similar path where citizens’ bank accounts can be dipped into in order to stabilize the broader system. There is an argument to be made for such a move as the alternative could be potentially disastrous, but its logic is lost on investors that may move capital out of the Eurozone preemptively – a possible capital exodus.

Where there was once relief seen in rescue options, now there is a sense of fear. And, if investors are attempting to move out of a possible bailout candidate (moreso than before), there will be a greater sensitivity to rising sovereign bond yields, liquidity issues, recession indicators and other recently casually ignored factors. So what countries are next in line after Cyprus?

Though they have already accessed aid, both Greece and Spain are key concerns moving forward. Even after Greece received its second debt restructuring and another round of support, the consensus was that the country would have to request more given the level of debt and depth of its recession. Having seen so many rounds of help absorbed, a more dramatic option may be brought up rather easily. Spain is in a different class. The size of the country may essentially overwhelm the traditional stimulus options. The trouble in the country is clear with real estate losses not fully realized, unemployment at a record, regional governments still locked out of the capital markets and the federal government extending its target for meeting its debt-to-GDP objective.

While both the above threats loom large, there may be more immediate troubles at hand in the coming week. Another overlooked Eurozone member, Slovenia could be thrust into the headlines after its 9-year sovereign debt yield surged over 40 percent over the past two weeks. Like Cyprus, it has an outsized banking sector and its government is very young (just over a week in office). On the other end of the scale, we have Italy. Only a month ago, the nation’s election ended in complete deadline – not a good state with a deep recession and the region’s largest overall debt. There is still no clear power structure, and it is needed to implement the changes the country needs.

There are two sides to every coin; and for the euro, the elemental risk-reward aspect is an assessment we should keep in mind. If Eurozone systemic crisis fears don’t flare through the period, the focus could shift to the ‘return’ aspect for the currency. On that level, the ECB is on deck and expected to maintain its steadfast hold against calls for stimulus to help offset austerity efforts. A hold translates into a shrinking balance sheet (and thereby higher market rates) due to LTRO repayments. That is a serious Fed and BoJ countrast…– JK

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29 March 2013 22:51 GMT