Last week, I was bullish on the euro (FXE) for the short term, but bearish for the long term. After a brief surge to start the week, the Dutch Finance Minister, Jeroen Dijsselbloem, dashed the bullish euro trade by saying that the Cyprus bail-in/bail-out was a template for other problems across the Eurozone. Following the market's reaction, Dijsselbloem and others quickly back-tracked on that statement. Clearly, there is a healthy debate going on in Europe about using Cyprus as a template. After much complacency in the euro/USD, as well as European bond markets, there were more indications of Cyprus fears impacting security prices last week. The ECB Governing Council is meeting on Thursday and I am waiting to hear Mario Draghi's perspective on using Cyprus as a template. The Draghi Put had a big impact on European security prices last summer; however, the Cyprus crisis has created a two-class euro that now challenges the premise of the Draghi Put. In this article, I will look at the recent price action in the euro, as well as several European asset markets, and discuss the Cyprus template issue.
Euro Could Not Hold $1.29
The euro closed the week at $1.281. Previously, I was bullish on the euro since it seemed to be holding above $1.29 and, more importantly, above the $1.26-$1.29 band that had been an important transition zone going back to early 2012.
The next major level to watch is the November low of $1.266 and the bottom of the band.
The first chart shows the long term price action in the euro and the second shows the price action last week. The big drop on the second chart was the market's reaction to Dijsselbloem's statements about using Cyprus as a template.
Clearly, the Cyprus situation weighed down the euro. But, it is also important to remember that Italy has not yet formed a government and that uncertainty is also a factor.
European Bond Yields
The European bond market showed some signs of contagion fears last week as the Spain-Germany and Italy-Germany 10 year bond spreads widened last week.
These moves are in contrast to the complacency of the previous week, but the spreads are still far off the extreme levels of last summer.
Spain's 10 year yield closed the week at 5.06%. The Cyprus crisis has probably halted the rally in Spanish bonds (and the drop in yield) from last July. Now it will be important to see if the yield can stay in the low 5% range or if there is a quick reversal. A longer timeframe (second chart) shows that Spain's 10 year bond spent a lot of time in the low 5% yield range over the last few years.
The story with Italian bonds is quite similar, but it is important to note that Italian bond yields have climbed more than Spanish bond yields in 2013. The Italian election mess is probably the driver for this.
European Equity Markets
The impact of the Cyprus situation can best be seen in the performance of the European equity markets.
Previously, the European equity markets were quite resilient in the context of the Cyprus situation. Last week, equity markets lost ground and the big losers were Spain and Italy.
The following chart shows the 5-day price action for: iShares MSCI Germany Index Fund (EWG), iShares MSCI Italy Index Fund (EWI), and iShares MSCI Spain Capped Index Fund (EWP) and the SPDR EURO STOXX 50 ETF (FEZ).
European banks were especially weak. The iShares MSCI Europe Financials ETF (EUFN) was down 3.05% in the last 5 days. Banco Santander (SAN), which is the second largest holding in the EUFN ETF (representing 4.8% of its value) was down 6.97% over the same period.
The following chart shows the EUFN and Banco Santander over the last year. They both had strong rebounds off of the July lows, but Banco Santander has given back a lot of the gains since the start of 2013.
Impact of European Equity Markets on US Equity Markets
Despite the declines in Europe, the US Equity markets have been strong. On Friday, the S&P 500 (SPY) closed at an all time high. Similarly, the Financial Select Sector SPDR ETF (XLF) has been strong, despite a recent pullback after the stress test results were released.
The following chart contrasts the US and European equity markets by showing the year-to-date gains in the SPY and XLF and the weak performance of the euro, EUFN ETF and the iShares MSCI EMU Index ETF (EZU).
Draghi: Is Cyrpus A Template Or A Stick?
Last summer Draghi announced that he would do "whatever it takes to preserve the euro." However, the Cyprus crisis has culminated in a de-facto two-class euro thanks to capital controls in Cyprus.
Draghi will have an opportunity to further explain his perspective about the Cyprus crisis this week. I doubt that he believes that the Cyprus bail-in/bail-out should be used as a template across Europe. More likely, the ECB and Germany wanted to use Cyprus as a threat to other countries, such as Spain and Italy. The ECB and Germany realize that offering carrots to get Spain and Italy to do what they want may not be enough, so they may have pivoted to using a stick.
The ECB tried to exert more control over Spain through the OMT program, but that hasn't worked yet. The launch of the OMT was a positive for the markets, but it did not force Spain to comply with the ECB. Maybe, a stronger message was needed.
There are other reasons why Cyprus may not be a template. It seems that Germany was strongly opposed to Cyprus as an offshore money haven, especially for Russia, and wanted to end that practice.
In general, the European markets have held up pretty well in face of the Cyprus situation. However, the comments by Dijsselbloem about Cyprus-as-a-template sent the euro, European peripheral bonds and European equity markets lower. We have a chance to get more color on the situation from Mario Draghi this week. Will we get a market friendly Draghi or not? Will Draghi endorse the Cyprus template or is Cyprus just being used as a strong warning that needed to be delivered to other countries? European markets are waiting for Draghi's take. Finally, Italy better decide on a government soon or that may become more of a catalyst to send markets lower.
Additional disclosure: I may trade any of the securities mentioned in this article at any time, including in the next 72 hours.