Cyprus: my views on this controversial bailout
A bad precedent has been set with the European bailout of Cyprus that, in its most benign form, leaves the EU in open conflict when it comes to Italy ( EWI , quote ) and Spain ( EWP , quote ). As well, this weekend's developments also begs the question, who is really calling the shots here?[caption id="attachment_62007" align="alignright" width="300" caption="The EU's decision to bailout Cyprus has been met with criticism"] [/caption]
This is the first time bank accounts have been involved in a euro zone bailout . Smaller investors -- those with less than $100k in deposits -- junior bondholders in Cypriot banks will be adversely affected; bank accounts are frozen.
A Russian loan to Cyprus worth $2.5bn that matures in 2016 is also in question and, unsurprisingly, Putin is all over the tape with threatening rhetoric.
What's next? The Cypriot Parliament needs to approve this edict. The vote has already been delayed, and may be delayed even further. Then, other EU countries will vote on the bailout, and then we can determine if there will be a renegotiation of the most onerous elements of the bailout conditions which appear to make all bank deposits vulnerable. Again, a precedent has been set in the name of a "unique situation" in Cyprus; is it really, or is this just a preview of much more difficult events to come in southern Europe?
The vote is key for markets; if parliament votes in favor, the risk-off events will be mitigated in the short term. If parliament doesn't approve the bailout, there will be concern about the potential failure of the entire Cypriot banking system and the implications of such a collapse. How hard are the core EU countries -- Germany, etc. -- willing to play, and does this imply that they view that this risk is not systemic? Right now, it's hard to know who is behind this aggressive action, though the IMF seems to be pushing hard for these measures.
The market implications hinge on the deal getting voted through and the details of the deal. The most worrying ramifications of all of this are that deposit flight risk will extend beyond Cyprus and there will be a further loss of confidence in the Cypriot economy. Cyprus has recently installed a pro-EU government, and this can only stoke the fire of leftist-leaning parties who are gaining power throughout Southern Europe, most notably in recent Italian elections.
This all comes at a time when equity markets are at an interesting spot. Going into this weekend, the US was at all-time highs and volatility was at all-time lows. As well, all 10 sub-sectors are up on the year, and realized volatility was between 5 and 6%, which is as low as realized volatility can get on the SPX. Implied volatility below 12 is a big deal as we have only seen these levels a couple of times since the 2006 lows.
Thus, it's too early to buy the dip down only 1% on a risk/reward basis. If you're long, the market has a lot of room to give back and volatility has plenty of room to move higher. Wait to see if this turns into something much more interesting before looking at more defensive markets.