Short Relief But No Enthusiasm For The EUR

Includes: DRR, FXE, UDN, UUP
by: Dean Popplewell

There are no new surprises with the Eurozone Houdini package reached last night. Everything was very much signposted late last week. Cyprus has little alternative, but to eventually agree to any harsh terms presented to them. Their one potential ally, Russia, was not interested - however, they may be now. The Euro-zone has on a number of occasions miscalculated the managing of public reaction because they keep underestimating the "will" of the people. Socially and culturally was always going to be the single currency biggest problem - and it still is.

This solution is damaging to investor confidence, especially the international investor. Investors to the EMU periphery will now be hesitant given the bailout of depositors of over +€100k. The Eurozone has managed to create a new and dangerous precedent that will affect capital flow. The markets will need to watch foreign investor appetite to the periphery regions to understand the direction of the 17-member single currency.

Cypriot bailout details:

  • The Cypriot support package will total €10b. All Euro-area members and the Troika have agreed to the package.
  • Laiki Bank will be wound down. Deposits under €100k will be guaranteed, but deposits above this amount will face losses, the full value of which is not yet known. Senior bondholders of Laiki Bank will join equity and subordinated debt holders in the bail-in. This process is expected to generate €4.2b
  • Small deposits and good assets of Laiki Bank will be transferred to Bank of Cyprus
  • In the case of Bank of Cyprus, equity holders, subordinated debt holders, and uninsured deposit holders will be bailed-in to facilitate recapitalization.
  • Cypriot banks will remain closed until when - not sure - and what controls on deposit withdrawals will remain in place.
  • Interestingly the implementation of the "bailout details" does not require any new approvals from the Cypriot parliament.
  • The Cypriot government is expected to use tax increases and privatizations to generate additional funding.

However, Russia remains the unknown variable in this periphery charade. In theory, the "Motherland" could react strongly to the deal to bailout Cyprus's banks. Supposedly, many Russian citizens hold deposits greater than the +€100k that is 'only' guaranteed.

The tail risk of Cyprus is less of a financial issue for markets. Investors will likely turn their attention back to Italy, another periphery problem. Already a month has gone by and the country remains government-less. The formation of a government in Italy will continue this week, and although the situation remains uncertain, most parties appear to prefer avoiding another immediate election. The market problem is that concerns over an unstable government will persist and an early election is always a high probability. An Italian problem flare up cannot be dealt with in any Euro-zone bailout programs. Liquidity programs like the ECB's OMT is a (government) 'conditional' program.

The EUR has held its own despite Italian political gridlock, a new precedent set in Cyprus and recent weak data out of Europe, especially German PMIs. These are obviously all-good reasons not to want to hold the EUR, however, investors did not want to sell. This week, expect investors again to look at US GDP revisions as an excuse to short the EUR. Analysts are expecting a wider divergence between the two economies, Europe and the US, after the released numbers. The key is to watch the Tsy/Bund yield spread. Thus far, bad news has seen many pare risk by 'not' selling the EUR. However, any good news should benefit the USD and boost risk appetite.

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