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A “Monumentally Dangerous” Cyprus Bailout Scenario

A “Monumentally Dangerous” Cyprus Bailout Scenario

Boris Schlossberg, Technical Strategist

The EURUSD careened lower in response to the controversial and unprecedented tactics being employed by Eurozone officials in order to rescue the now-insolvent banking sector in tiny Cyprus.

It's been a very volatile start to the week in FX, with EURUSD gapping lower by more than -100 points on news that the European Union (EU) approved a deal that would tax Cyprus bank deposits in return for the financial rescue of the sector. The pair tumbled to hit a low of 1.2881 in late Asian trade on fears of contagion to the rest of the Eurozone. Investors grew increasingly concerned that such schemes could be employed against other periphery members as well.

The Cyprus banking rescue deal evoked howls of protest from the markets and analysts alike, not only because it confiscated part of depositor funds, but also because it levied the tax on small depositors under EUR 100,000, breaking the fundamental issue of trust in the financial sector.

The outcry has been so loud that the Cypriot Parliament is now in the process of modifying the deal to make it more progressive by lowering the tax to 3.5% for those who hold deposits under EUR 100,000 and raising it to 15% for those with deposits above EUR 500,000.

By mid-morning European trade, sentiment had settled a bit and EURUSD regained the 1.2950 level after short covering kicked in. Despite the hand wringing that accompanied the weekend deal, Cyprus may be a unique situation in the Eurozone, both because of its tiny size and its well-known reputation as a center for money laundering. Therefore, the financial deal offered Cyprus is not one that is likely to be repeated anywhere else in the Union.

Still, the precedent of deposit confiscation is not one that Eurozone investors will soon forget, and as such, the nervousness regarding the safety of funds in other periphery economies could persist for some time. The EURUSD is likely to trade cautiously for the next few days, and sellers are likely on every rally. For now, the pair appears to have weathered the storm, and 1.2900 is now acting as key support.

The most immediate risk for the pair is the vote in the Cypriot Parliament. According to the latest polls, fully 70% of the population opposes this deal, but the governing authorities may have no choice but to approve it given the fact that the nation’s banking system is insolvent and would collapse without EU support. If the Cypriot Parliament approves the deal in whatever final form it takes, the market is likely to breathe a sigh of relief, and EURUSD could rally towards the 1.3000 handle at that time.

However, if the Cypriot saga drags on, the damage to investor sentiment and the possible hoarding behavior that it could trigger among savers all across the Eurozone could prove monumentally dangerous to the financial stability of the region and precipitate a much steeper EURUSD selloff over the next few days.

See also: Risk Remains After Cyprus Bailout Vote Is Postponed

By Boris Schlossberg of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.