The euro Mummy returns. It’s no Boris Karloff incarnation, but it could be the market’s worst nightmare. The creature is back, lurching about, bandage clad and scaring the living daylights out of risk perceptions again. It is a horrible vision. The body has been embalmed as well as possible by the ECB and bandaged up to prevent any further decay, but it’s not going to stop the horror show from unfolding further. The spectre of euro-risk contagion is back to haunt us. The proposed Cyprus rescue may be small fry relative to the bail-outs in Greece, Ireland and Portugal but this time it adds a new dimension of risk. The proposal for a bail-in involving depositors might seem an appropriate political concession to Germany, aiming to recoup nearly two thirds of the expected 10 billion euro rescue. But it is not a smart move from the perspective of heightening the risk of future bank runs. While depositor funds might have been ring-fenced in this instance, the risk of precedent setting could take a terrible toll in future Eurozone country bailouts and bail-ins. Depositors have been warned and will be ready to run in future. While the ECB is insisting that Cyprus is a special case, since the scale of the banking sector outweighs GDP there by a factor of 8, it nevertheless opens up a fear of being repeated in other situations. If the risk of an EU bail-out gets a grip in Spain, it could trigger a massive run on the Spanish banks that could spell a new wave of financial risk, not just for the banking sector there, but for the Eurozone at large.
While Draghi’s commitment last year to ‘do whatever it takes’ to solve the Eurozone crisis helped seal much of the contagion crisis in the last eight months, the Cyprus ‘solution’ has clearly opened up old wounds again. With the vote in the Cyprus parliament postponed until tomorrow, the short term outlook remains very unclear for markets especially since the vote will be a close run event. The Cyprus parliament could easily reject the deal, given the high degree of domestic political opposition. It would be dynamite for markets, as the country would go into immediate default opening up risk crevasses everywhere across the Eurozone. This would sound a definite death-knell for the recent 4-month rally in stocks, intensifying spread widening pressure in beleaguered high yield Eurozone bond markets in the process. The euro would return to square one of deep uncertainty about the Eurozone breaking apart and the currency disappearing out of existence again. The usual safe haven plays of running into the safety of the front end of the German curve and bailing into Swiss francs would continue to dominate sentiment.
All hope is not lost for the moment. The Cyprus parliament could accept their lot and vote the bail-in measures through, or attempt to restructure the deal, watering down the severity of the hair-cut for poorer depositors. It should also be remembered that Cyprus is not a lost cause as the country has the advantage of sitting on significant oil and gas reserves that might be worth up to 300 billion euros, a huge bonanza for a country worth an estimated 15bn euros. The intrinsic problems of the Eurozone would still remain firmly entrenched though. Italy remains a powder keg of contagion risk for markets while the political situation remains deeply gridlocked and Beppe Grillo refuses to play ball with the main political parties. Spain remains subsumed by deep-rooted banking and recession risk. The Eurozone remains in the grip of deep recession forces, unemployment is high and spreading political dissent is continuing to rise. There is no chance of breaking free of the crisis while fiscal austerity continues to hit the Eurozone economy hard. The only way forwards is via the soft route of a u-turn in fiscal policy, combined with an ECB adding to recovery hopes by massive pro-cyclical monetary stimulus. Either way, the euro is destined to go weaker. It either suffers the shock of a deepening Eurozone contagion crisis, or else follows the same monetary debasement route that has happened in the US, Japan and the UK, which has holed the dollar, yen and the pound below the waterline. A break down towards the USD1.25 level should be on the cards in the next 1-3 months and further out a re-test of USD1.20 remains a high possibility over the next 3-6 months. The risk-rally remains postponed for the time being.
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