All Eyes Off Cyprus - Where Next?

Includes: DIA, SPY, VIXY
by: Technical Titan

As soon as news broke out about the Cyprus bailout, every media outlet (as if to put off its importance) began speculating on the NEXT bailout - Slovenia, Italy Portugal. How about Japan?! Now I have your attention.

In March, after weeks of negotiations to prevent the seemingly inevitable default of this tiny island nation and its unprecedented removal from the eurozone, Cyprus, the third smallest member of the EU, secured a 10bn Euro (13bn USD) bailout from the European Union, the European Central Bank and the International Monetary Fund. It is the fifth country to tap international aid since the crisis broke out in Greece in 2009. Appearing to be yet another victim of the three year-old European debt crisis and arguably too small to be relevant to the health of the entire eurozone, there are many factors that forced the recapitalization of the largest Cypriot banks and spurred chaos across the region. I want to answer a few questions about the situation in Cyprus because, honestly, it seems as if everyone simply forgot a week after banks reopened.

Imagine the Cayman Islands in the Mediterranean Sea - a tax haven for businessmen, rich Russians and more than a few 'characters' that should be on OFAC's SDN List. With a population of 1.1 million as of 2011, and its GDP close to $24 billion (PPP) in 2012, Cyprus actually plays an important role in the EU.

What Happened?

Europe basically completely lost its ability to manage its debt crisis; and many of the "impossibilities" became realities in the last few years. In an attempt to protect the integrity of the euro and its partners, European creditor classes (both sovereign and private sector) incurred insurmountable amounts of debt and today, after steep losses, they are at risk of being bailed in and/or subordinated by "rescue funds." In Cyprus' case, they lent money to Greece. After the Greek economy tanked, Cyprus did not simply cut its losses - it doubled down by buying government bonds hoping for a bailout, and now it owes more money than its own GDP. So a bailout deal was agreed upon, with one caveat - Cyprus had to raise a large sum of money from internal sources before receiving aid from the IMF. Cyprus decided to tax the savings accounts of depositors. Cyprus' second largest bank - Laiki Bank - was closed down and deposits above 100,000 euros moved into a "bad bank." Deposits below 100,000 euros will be moved into Bank of Cyprus, the country's biggest bank, which is being significantly restructured. Emergency measures were taken to secure this money:

-Accounts over 100K were frozen and the funds contributed towards the bailout deal.

-All customers of Cypriot banks will face a one-off tax starting at 6.75%.

-Additional talks speculate that as much as 40% of account balances would be converted into bank shares.

-Branches were closed for two weeks; ATM withdraws were limited under strict capital controls.

So why did U.S. markets prevail under such a heightened sense of uncertainty and news of the closest any nation has gotten to default?

U.S. markets did not seem affected about the lingering global economic turmoil. U.S. stocks futures rose even before Cyprus's lender restructuring deal was reached -- investors are confident that "Europe will figure it out." During a Wall Street Journal Live report, Jonathan Cheng, a Wall Street Journal reporter stated the following list of reasons why U.S. markets will not be derailed by lingering economic turmoil:

-Dow Jones is at an all-time high.(DIA vs. ^DJI comparison below)

-As the futures suggest S&P 500 also reached a record high the week of the bailout agreement (S&P500 vs. SPY comparison below).

-Companies in the U.S. are earning more money than ever.

-ECB, FED, BOJ are pumping money into the system and reaching the consumers so as to allow these companies to earn more because of increased spending. [I disagree with this]

-Market confidence despite economic turmoil oversees is proving the less risk adverse investors are seeing the inherent returns.

-Gold falling is an indicator that investor risk profile leans toward equity.

-VIX (fear gage) at six-year low (^VIX vs. VIXY comparison below)

However, as investors we must realize, and anticipate, that American markets will have to correct themselves for all the rapid growth in the near future - arguably in relation to the state of the global economy (if it continues to suffer), but also independently of external influences.

Why was Cyprus so important?

As part of the original formation of the economic and monetary union (EMU), no country is supposed to leave the eurozone in order to prevent fallout and maintain confidence in the currency. This is why Cyprus was so important - it would break the "taboo" if the bank plan was not passed.

Cyprus must be the last sovereign crisis in Europe, because the next one cannot be contained. At a minimum, the north (Germany, Russia, and Netherlands) will require concessions before putting national taxpayer funds at risk for the benefit of non-residents. As falling mood and economic "fatigue" increases, each nation will do what's good for itself and its citizens.

***Source: - Euler Diagram

So where does Japan fall into all this - or did you forget that I mentioned Japan as the next candidate for a bailout in the first sentence of this article - almost like you forgot about Cyprus?

"…Past figures in Japan as well as in Europe and the U.S. show that the link between monetary base and prices has been broken," said outgoing Governor of Japan, Masaaki Shirakawa. This refers to the fact that printed money in the U.S. and Europe hasn't flowed through to economies as banks have sat on the money rather than lent it out (also the reason why I disagree with Jonathan Cheng's comments - previously stated in this article). Of course, if you review some basic data about Japanese economic conditions, you will see that during its 23-year old deflationary cycle, Japan's government debt is higher than half of all European debt as a % of GDP combined [see figures at end of article]; and total debt to GDP is over 500%, trumping any other country in the world. Still thinking about Cyprus?

Over 948.4 trillion yen in JGB as of Sep 2012 at 77.995Yn/USD (9/30/12 Close) translates to 12.16 trillion USD...90% of holders being domestic (Japan)

Trends indicate that the devaluation of the yen will continue to figures weaker than in April of 2009, and the Japanese government does not seem have a level at which its weakness would be viewed as excessive. Paul Lambert, head of currency at Insight Investment, said: "I don't think we have reached a level yet where the Japanese government is uncomfortable with the value of the yen. At the other extreme, last year $1 was worth short of 80 yen and it was affecting the competitiveness of big exporters such as Toyota and Sony, which resulted in additional requests for bailout by large Japanese firms in several industries, including electronics, nuclear power and banking [Toyota requested bailout in 2009]. Now, because of such a weak currency, they are facing increasing import costs that will directly affect people's lives in a negative way.

This is a REAL Crisis, what will Japan do?

There is another attempt in place (as it was done in 2001-2006) to establish and maintain inflationary targets of 2%. Bank of Japan plans to expand its 101 trillion yen asset buying program by more than 10 million yen (hardly significant in comparison). The idea behind the strategy is that you create money out of thin air, use that money to buy government bonds off private institutions and others, thereby increasing money supply and possibly inflation. Also, the institutions will start lending the money out, thereby kick-starting spending and the economy. I suppose the theory is that if money is printed inflation will come because the correlation between money supply and inflation is high.

My Opinion

Very simple, in honor of the basic fundamental players in this economic disaster [Debits and Credits], the fiscal deficit should close. It is far too early to tell whether U.S. stimulus policies have worked, but certainly a mixture between public spending and aggressive quantitative easing will prove most successful. Currently U.S. debt as a % of GDP is at roughly 330%, European total debt as % of GDP is reaching 400%, and Japan's currently sits at 245% (government) and over 500% total. Effects of the devaluation of the yen and debt issues are affecting surrounding local economies like South Korea and Taiwan; as currency wars are already under way. Like Europe, Japan prefers to print money than cut spending. This will most certainly spark (sooner than later) another and much larger economic crisis in Asia, dwarfing the current situation in Europe.

What is your opinion? Please know that I welcome dialog and criticism regarding any of my articles; if anyone finds an error, please point it out to me in the comments.

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.