Cyprus: Low Volatility And Risky Plans

Includes: FXB, FXE, FXF, GLD
by: Dr. Duru

"On Tuesday, March 19 we would either choose the catastrophic scenario of disorderly bankruptcy or the scenario of a painful but controlled management of the crisis, which would put a definitive end to the uncertainty and restart our economy…We are not aiming to gloss over the situation. The solution chosen may be painful, but it was the only one that would allow us to continue our lives without adventures. It's a decision that leads to the historic and permanent rescue our economy." - newly elected Cyprus President Nicos Anastasiades in a press release on March 16, 2013 explaining the choice to levy a tax on depositors to help pay for a major bank bailout. These taxes will fund the purchases of shares in Cyprus's two major banks that are teetering on the edge of bankruptcy.

While it is still far from clear that the risky bailout plan for Cyprus will pass the country's legislative body -- a vote that was scheduled for Sunday has been postponed to Monday at the time of writing -- it does seem clear that the unprecedented plan to seize money from even insured savings accounts is causing worries about financial contagion. The violation of the guarantee of "safety" for accounts worth less than 100,000 euros ushers in yet another phase for the eurozone crisis. Europeans, and maybe others, awake to the possibility that when push comes to shove, guarantees of safety may not be worth much, and/or that the notion of safety is a relative not an absolute one. This is a risky path because so much of the financial system's functioning relies upon confidence.

Of all the things that can undermine confidence in the financial system, a sense of unfairness and inequity could be the most damaging in this case. The involuntary and essentially arbitrary seizure of funds violates a fundamental premise of security that could exist in a system. It seems senior bank bondholders and investors in Cypriot sovereign debt are not being forced to take losses -- no doubt because Cyprus wants to maintain its ability to borrow in the future. Such ability may mean little if no one wants to deposit any more money into the system.

While many factors played into the construction of the current plan, I am assuming that important enablers are the low level of volatility in global financial markets and the related notion that the eurozone has finally conquered tail risks for its currency. These presumptions of reduced risk give rulemakers a (false?) sense of security and a larger platform for taking risks. On the surface at least, it seems the financial system has plenty of buffer to contain and absorb any fallout.

Cyprus's small size probably contributes to the notion that whatever happens in the country can be well-contained. If Greece is small potatoes, then Cyprus is a potato chip (a phrase I happily borrowed from a friend, as potatoes are a major Cypriot export). (Ironically, Cyprus is in a jam partially because of the haircut its banks suffered in the restructuring of Greece's debt -- contagion at its finest). At 0.2% of the eurozone economy, Cyprus's economic output is roughly the equivalent of Vermont's. However, unlike Vermont, the total value of its financial sector is about 8x the size of the economy. Cyprus is also mired in recession, as the economy has recorded five straight quarterly declines in GDP. Year-over-year changes for these quarters were also negative. Along with this deposit tax, Cypriots are facing austerity budget cuts. The double whammy is sure to lock Cyprus into a recessionary spiral for some time to come. So the small global impact that Cyprus will likely have is of zero comfort to Cypriot citizens.

So contagion does not respect size, and what seems small now could certainly loom very large in the future. In the currency markets, this means opportunity. I earlier pointed out that it was hard to buy into the optimism in Europe while at the same time the eurozone seemed to be at the center of the United Kingdom's economic problems (see "Pound Vs. Euro - Debt Downgrade Vs. GDP Downgrade"). It now appears that the euro (NYSEARCA:FXE) is ready to reverse a large part of recent gains against the pound (NYSEARCA:FXB). In an earlier piece, I even concluded that EUR/GBP had topped out (it seems I was about a month early in that call).

EUR/GBP finally breaks down below its 50-day moving average

Suddenly, the British pound should look a lot better than the euro for the months of turbulence likely ahead.

Of all the euro-impacted currencies to watch during whatever unfolds, I will focus again on the Swiss franc (NYSEARCA:FXF). EUR/CHF provides an indicator of risk appetite toward the euro: particularly when it is on the rise, perceived risk in the euro is diminishing. When I last wrote about this currency pair, I pegged 1.22 as a level to get aggressive on buying. That worked out well, but the trade was fleeting, as failure to hold 1.23 got me out of the trade. Now, assuming the euro faces weakness in the short-term, I would like to get aggressive starting somewhere below 1.21. This, of course, assumes that the Swiss National Bank (SNB) will continue to defend successfully its 1.20 floor, and, eventually, the euro will recover from this latest mess. The SNB may have to take more drastic action against capital inflows if a Cyprus contagion flares much worse.

2013's rally for EUR/CHF finally looks ready to completely reverse, completing the work of February's plunge

Above all, I think gold (NYSEARCA:GLD) should shine again. Gold and silver have been much aligned given the growing assumption that all is once again working well for paper currencies. Cyprus is just one of many reminders that paper currencies remain the playthings of politics, treasuries, and finance ministers. At current levels, gold looks like a steal, assuming that the current era of low volatility is the mirage I think it is.

GLD has struggled for almost two years to regain its bullish tint, but it has held recent lows very well.

Source of charts:

Through it all, traders must keep in mind BOTH the bearish and bullish opportunities that renewed volatility present. After all, the Cyrpus crisis could well go the way of all the other past eurozone crisis… another big dip and buying opportunity that gets smaller and smaller in the rearview mirror. In other words, do not chase panics downward and keep position sizes small.

Be careful out there!

Disclosure: I am long GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.