Going to be ugly in Euro-land tomorrow.
Readers digest version: Cyprus broke. Needs money. Will tax its own citizens’ bank deposits to raise funds. Ugly. We’re more broke than Europe. We’re next. Could happen here. lol.
From: DAVID ZERVOS (JEFFERIES LLC) [mailto:*@bloomberg.net]
Sent: Sunday, March 17, 2013 06:45 PM
To: slut
Subject: Die Republik Zypern
What happened to Cyprus on Friday evening was one of the most significant developments in the Eurozone since the Greek election last summer. To tax the bank deposits of savers sends an ominous message to the entire global investment community. All of us should really take a moment to consider what the governments of Europe have done. To be clear, they initiated a surprise assault on the precautionary savings of their own people. Such a move should send shock waves across the entire population of the developed world. This was not a Bernanke style slow moving financial repression against risk free savings that is meant to stir up animal spirits and force risk taking. This is a nuclear war on savings and wealth - something that will likely crush animal spirits. This is a policy move you expect from a dictatorial regime in sub-Saharan Africa, not in an EMU member state. If the European governments can clandestinely expropriate 7 to 10 percent of their hard working citizen’s precautionary savings after the close of business on a Friday night, what else are they capable of doing? Why even hold money in a bank account? Are they trying to start a bank run?
Sadly, the politicians that are responsible for this travesty likely don’t even understand the unintended consequences of their actions. Instead, they just have a simple myopic goal - to get reelected. And because the SPD has consistently attacked Merkel over bailout payments from German taxpayers to Russian oligarchs, action had to be taken. The German elections are coming up quickly, and Merkel needed to quiet the opposition. She needed to appear tough - not like a leader who would just throw away hard working German taxpayer euros to a bunch of Russian tax dodgers. The plan was simple - haircuts on deposits. The German electorate would applaud her bold actions. She would be teaching the bad guys a lesson. And what could go wrong? Its only little old Cyprus - its too small to matter.
But how would she get the peripheral FinMins to agree? The southern contingent would block the move for sure - unless of course they were bought off. Its was a masterful plan - give the already beaten down peripherals better bailout terms in exchange for a transparent domestic political win on the Cyprus issue. The German electorate will think the weaker bailout terms for Ireland and Portugal are just a reward for following the mindless austerity measures. And in turn, the bulk of the attention will focus on the fact that German tax dollars were kept away from Greeks and Russians.
Maybe I’m wrong. Maybe it didn’t really go down like that. But as I see it, there really is no other explanation for taking such extraordinary risks with bank stability. And what are those risks? Well the tax is still not a done deal in Cyprus. The parliament could reject it. We will find out Monday evening (maybe) - and if it is rejected, then Merkel’s game of chicken for political gain will backfire. She will lose the bet that Cyprus is not big enough to be systemic. If the Cypriots just stand up and say - “ok kick us out and we’ll keep the 10 yards of Target 2 balances and leave” - she will be up against a very painful wall. It will actually be up to the ECB to either cut off the ELA and force a Euro exit for Cyprus, or allow the ELA to pay off ALL depositors during the ensuing bank run. Importantly, the central bank governors are not the same as the FinMins. And it is NOT likely they would all agree to cut the ELA. And, if the Cypriots exit, it would likely cost the member countries even more than the bailout (as the Target2 money would stay in Cyprus). Although the Cypriots may not recognize it, they actually have a very strong bargaining position for a much better deal.
Now while the possible exit trade sounds entertaining and exciting, it is not the likely scenario. In the end the Cypriot parliament most likely bows to the Germans and passes the tax legislation. Then, peripherals widen across the board and the Euro weakens. The question of course is how much. A good guess at the initial reaction on Monday is -1.5/2 percent in EURUSD and +25 to +50 bps in peripheral 10yr spreads. Importantly, there could be a lot of uncertainty Monday if the Cypriot parliament is still in debate as the markets open. Of course risk assets globally will surely be soft.
And if the Cypriot parliament agrees to the tax, we should also see some serious instability develop at peripheral banks. Why keep your money at a Spanish or Italian bank when you can jump to Germany or France. And why even keep money in the Euroarea banking system at all. We should see huge outflows. Maybe I’m wrong and deposits stay sticky, but the risks here are HUGE and SCARY.
Right now, I would argue that the risk of an EMU exit by Cyprus is real. And this is much more of a clear and present danger than anything happening in Italy or Spain. And even without passage of the tax, the potential for a bank run is very real. As a consequence, these events are MUCH MORE important than the Italian election results, or frankly any other issue in Europe.
So how do we play this? As most readers know, my long term baseline for EMU has always been that we would see the Germans eventually crushed on their policies of bail-ins and austerity. This is a clear short term loss for this view that we are headed towards a long term “Lirafication” of EMU. I did NOT expect the Germans to get a PSI on Cypriot bank deposits. For me, it is a shocking outcome!!
That said, I still fully expect that Mario will forcibly stop contagion with the most powerful financial instrument in Europe - the ECB balance sheet. But Mario might hang back a bit if things get messy. He admonished Schauble back in January not to go down the bank deposit haircut path in Cyprus. He warned that Cyprus is systemic. The Germans are taking a serious risk with financial stability for pure political gains. Its a nasty game and Mario will NOT be pleased. He may in turn want to teach the Germans a lesson and let them squirm a while before he brings out the bazooka.
So while we are still on the long-term path to “Lirafication” of the Eurozone, this event strikes me as having great potential to create short term instability no matter what the Cypriot parliament decides. And taxing deposits in a “developed” country is uncharted waters - the reaction by ALL global investors could be very dramatic. For those in the long risk trade, who have enjoyed double digit YTD returns (ie spoo/nky plus blues etc etc), hitting a few bids on the sunday night open seems a very sensible strategy.
I hope I am wrong about the severity of this action. But the prudent thing to do is lighten up/hedge. Then you can watch from the sidelines and buy the dip (which could be pretty large) as it becomes clear that the German attack on reflation eventually falters. To put this policy action in the context of my commentary last Friday morning, what the Eurozone FinMins agreed to Friday evening was a bit of trepanning. My head is already starting to hurt!!
So get a good nights sleep. It will be all eyes on the Cypriot parliament for the next couple days. And my best guess is that things get quite messy this week. Good luck trading.
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Voodoochild
