Abenomics Vs. Cyprus Jitters

by: George Liu

Talks of a worsening Eurozone crisis are back following the Cyprus fiasco. Cyprus' parliament has rejected its government's bailout deal with the Eurogroup and the IMF, which became a lightning-rod of controversy following the inclusion of a deposit tax of 6.75% on Cyprus bank deposits of less than 100,000 euros and 9.9% on deposits above that. Although the bailout was somewhat understandable given the unique conditions Cyprus faces and although later revisions made the deposit tax more progressive and exempted depositors with less than 20,000 euros from the tax, not a single vote was cast in favor of the bailout.

Now the Cyprus government is scrambling to find sources of funds for the 5.8 billion euros the Eurogroup wants it to raise for the bailout while the Eurogroup is scrambling to decide how it will respond if Cyprus ends up not raising the funds. Cyprus is also looking at other sources of relief: it is negotiating a 2.5 billion euro loan from the Russians and reportedly considering selling one of its major distressed banks to Russian investors for 4 billion euros. Even the head of the Cyprus Orthodox Church has stated that the church will put its assets at the country's disposal if needed. However, no significant progress seems to have been made and Cyprus is still faced with a ticking time-bomb.

So now, investors are faced with a two-pronged fear of contagion: fear of Cyprus not receiving bailout funds, declaring bankruptcy, and catastrophically exiting the Eurozone, and fear of the precedent set by the Eurogroup in utilizing deposit taxes as part of its bailout. As noted by Christine Lagarde, the Managing Director of the IMF, there is a significant potential for "contagion risks" due to the Cyprus crisis.

In the immediate reaction to the controversial Cyprus bailout and deposit tax, conventional safe-havens such as the Japanese yen jumped as investors become more risk-averse. The yen shot up 2% relative to the dollar and 2.2% relative to the euro when markets opened after the announcement of the deposit tax. Moreover, Marc Chandler has said that the Cyprus crisis has interrupted the "yen devaluation story" and many expect the yen to strengthen following the Cyprus drama.

This development is particularly interesting because it brings to full view the direct clash between two forces that are currently dictating the yen's performance: Abenomics and the yen's status as a safe currency. Abenomics is the term given to Japan's current economic policy, which involves massive increases in monetary and fiscal stimulus as well as structural improvements to the Japanese economy. Abenomics is the primary reason the yen has weakened by 20% since November 2012, which is a significant positive for Japan's export-driven economy (as well as for George Soros, whose fund made $1 billion betting against the yen). On the other side of the spectrum is the yen's status as a safe-haven currency, which means that investors will flock to the currency when there is economic turmoil in the international economy. This is partly due to the yen's strong liquidity, Japan's history as a traditionally trade-surplus country and Japan's position as a net international investment surplus country.

So which force will win in the end? It is very likely that Abenomics will win out over investors' fears about Cyprus and the yen will continue its depreciation. For one, the government under Prime Minister Shinzo Abe is determined to do "whatever it takes" to revive the Japanese economy, a central component of which is a weakened yen. This is a powerful statement, considering that Japan has, theoretically, unlimited firepower to pursue this goal.

On the other hand, the troika is determined to preserve the Eurozone and stop any potential contagion effects. Even though Cyprus rejected the bailout, the European Central Bank has stated that it will "provide liquidity as needed within the existing rules." Moreover, it is also highly unlikely that the troika will cut off funding for Cyprus' banks given that the ECB needs two-thirds of its board to cut off ELA funding (and Germany was basically the sole proponent of the controversial deposit tax). The relatively small size of the amount required to bail out Cyprus should also quicken a compromise. And if that doesn't work out ... well there's always the Russians.

It also seems as if investors are tired of getting worried about Cyprus. European markets rallied the day after Cyprus rejected the bailout offer and Larry Fink, Blackrock's CEO, summed up investor sentiment about Cyprus when he said he wasn't particularly concerned about it because "it's a $10 billion issue." Other safe-haven assets, such as gold, have not been significantly impacted following the bailout rejection, showing investors' relative confidence that the Cyprus fiasco will be sorted out soon.

Although the Cyprus bailout initially shocked international markets, in the medium-term the yen is still a one-way trade as it will continue to depreciate due to Abenomics and, overall, a strengthening global economy. Look for yen ETFs such as (NYSEARCA:FXY), (NYSEARCA:YCL), and (NYSEARCA:JYN) to continue decreasing in value and short-yen ETFs such as (NYSEARCA:YCS) to continue increasing in value. On the same note, don't expect Euro ETFs such as (NYSEARCA:FXE), (NYSEARCA:EUO), (NYSEARCA:EUFX), (NYSEARCA:ULE), (NYSEARCA:ERO), and (NYSEARCA:EU) to be significantly affected by Cyprus either.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.