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July 26, 2012 was a significant turning point for the markets when Mario Draghi, ECB chairman, said, "Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro and believe me, it will be enough." The Draghi Put sparked an immediate turnaround in the Euro (tracked by the CurrencyShares Euro Trust (NYSEARCA:FXE)), and a shift from "risk off" to "risk on" in equity markets.

The Cyprus situation is the first European crisis since the establishment of the Draghi Put. It is devastating for the citizens of Cyprus, but seems over-hyped for reasons discussed below. Nonetheless, there still is risk that the problems of Cyprus may spread, so I am watching how the Euro and other asset classes are trading in relation to their levels before the Draghi Put. My thesis is that the Draghi Put changed the dynamics in Europe, especially with regard to contagion, but the Euro and the bond market will indicate if it really has power or if there is cause for concern. See below for the key levels to watch.

Background On The Draghi Put

Mario Draghi's famous July 26 speech came at a time when the Euro was crashing as bond yields in Spain and Italy shot up on concerns mounted about the debt levels. The speech was followed on August 2 by the ECB's launch of the Outright Monetary Transactions (OMT) program. Under the OMT a troubled country, say Spain, can ask the ECB for assistance. If the country accepts certain conditions, then the ECB will buy bonds in the secondary market to help bring down borrowing costs. Initially, it was assumed that Spain would participate in the OMT program. However, Spain did not want to accept the ECB conditions and was / is trying to work out its problems in other ways. Nonetheless, the OMT created the impression that the ECB can prevent contagion (one weak country's problems spilling over to another). The fact that the ECB is ready to act, and has the tools to act, has been enough to settle the markets.

Cyprus

As sad as the situation is for the people of Cyprus, the Cyprus crisis should not matter for the global markets. However, what happens in Cyprus could establish precedent for other countries, such as Spain and Italy. Furthermore, people in other countries may fear that their bank deposits are not safe and unleash a bank run, like in Cyprus.

I do not want to dismiss these risks, since it will take time to see how the Cyprus situation unfolds. However, unlike Spain and Italy, Cyprus has very little bargaining power against Germany and the ECB, which are behind the tough deal that Cyprus will hopefully accept. As the saying goes, when you have a $10 million loan to the bank, you owe the bank. When you have a $10 billion loan to the bank, you are the bank's partner.

Cyprus can't say no to Germany, but Spain and Italy, despite their problems, have some leverage. Furthermore, Draghi said that he will protect the Euro. If Cyprus rejects the current deal and leaves the Euro, the impact on the Euro will be small. However, if Spain or Italy leave, or threaten to leave, the Euro as we know it may cease to exist.

I think there is a recognition that the Cyprus situation will not be a precedent for other countries, but let's look at the charts of the Euro, European bond markets and European stock markets to see if / when Cyprus' problems spread.

Charts of Euro And Other European Asset Classes

The first chart shows the price action in the Euro/USD, which is trading at $1.296. The key levels for the Euro are ~1.29 (the lows from today) and ~1.26. The Euro fell below these levels during the crisis of last summer and was only saved by the Draghi Put. Ideally, the Euro would stay above the upper level, but even staying above the lower one is a good sign. However, if the Euro breaks ~1.26 it might erase all of the impact of the Draghi Put.

(click to enlarge)

(Source: FreeStockCharts.com)

The CurrencyShares Euro Trust is one way to play the Euro's price action. There are some slight differences in price levels, but the FXE basically tracks the Euro/USD, so please note the following chart as well.

(click to enlarge)

(Source: FreeStockCharts.com)

Next, let's look at Spain, the main culprit of last summer's problems and a candidate for possible contagion. The first chart shows the yield on the 10 year Spanish bond, which is 4.96%. This is very low compared to the levels of last summer. Ideally, the Spanish bond yield would stay below 5%, but even staying under ~5.5% is encouraging.

The second chart shows the 10 year Spanish bond (orange line) relative to the 10 year German bond (green). The vertical line represents the day before Draghi's speech. The Spain-Germany spread is currently at 355 bps compared to 611 bps prior to the Draghi Put. It is important to see if this tight spread can be maintained.

In general, the Spanish bond market looks to be in relatively good shape. This may change due to Cyprus contagion and these key levels will give an indication if that occurs.

Spain's 10 Year Bond Yield & The Spain-Germany Spread

(click to enlarge)

(Source: Bloomberg)

The situation in the Italian bond markets is similar. The Italian 10 year is trading at a yield of 4.63% and the key levels to watch at 5.0% and 5.2%. The Italy-German spread is now 322 bps, compared to 518 bps before the Draghi Put.

Italy's 10 Year Bond Yield & The Italy-Germany Spread

(click to enlarge)

(click to enlarge)

(Source: Bloomberg)

Finally, a look at the European equity markets. The following charts show the price action over 1 year and since July 25, 2012 (the day before the Draghi Put) for the following ETFs: iShares MSCI Germany Index Fund (NYSEARCA:EWG), iShares MSCI Italy Index Fund (NYSEARCA:EWI), and iShares MSCI Spain Capped Index Fund (NYSEARCA:EWP).

Over the last year there was a lot of volatility, with a big drop until the Draghi Put and then a 30-50% rally. It will be interesting to see if the gains can be maintained despite the headlines form Cyprus.

EWG Chart

EWG data by YCharts

EWG Chart

EWG data by YCharts

Conclusions

I don't think that the Cyprus crisis will impact markets like the events of last summer. The Draghi Put has introduced a new dynamic to the market and there is a difference between problems in Cyprus and problems in Spain / Italy. I plan on looking at Euro, Spanish / Italian bond yields and the European equity markets for indications of the strength of the Draghi Put or potential contagion from Cyprus.

In the near term, the 1.29 level on the Euro is the most important to watch.

I expect that Q1 earnings season, which starts in 3 weeks, will be the main catalyst for the continuation (or end) of the rally in the S&P 500 (NYSEARCA:SPY) up to all time highs, as I explained in my previous article." Earnings, not Cyprus, will likely matter more for U.S. investors.

Finally, please let me know if you are interested in an updated version of this article next weekend to gauge how these securities react over the course of the week. I will be looking at these charts and if you are interested in following along, please let me know in the comments section below.

Source: Impact Of The 'Draghi Put' On The Cyprus Crisis And Key Euro Levels To Watch

Additional disclosure: I may trade any of the securities mentioned in this article at any time.

Disclaimer

Please note that I have no information about the actual plans of any of the companies mentioned in this article. I do not speak to the executives of these companies and these thoughts are purely my own observations. They may be accurate or not and any of the trends mentioned above could take a very long time to materialize, if at all, so please do your own homework. If you disagree with me, please feel free to comment below.

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