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3 Safe Harbors from the Cyprus Debt Fiasco

3 Safe Harbors from the Cyprus Debt Fiasco

Kathy Lien, Technical Strategist

The controversial bailout of Cyprus’ banking sector continues to dominate the markets and put pressure on the euro, causing traders to look to the US and Australian dollars, and even the British pound, for growth and relative safety.

The euro remained under pressure against all of the major currencies throughout the North American trading session on Monday, and while the EURUSD rebounded off its earlier lows, the fiasco in Cyprus is constantly evolving, making any recoveries fleeting. At one point, it was thought that the Cypriot Parliament's vote on the levy on depositors would be postponed, but at the time of writing, Reuters had confirmed that the vote will take place as planned on Tuesday.

European Union leaders appear to have given Cyprus a bit of flexibility, but no details have yet been provided. Some speculate this could mean protection for depositors with less than EUR 100,000 in their accounts, but even this may not be enough to prevent the euro from falling.

Needless to say, this is a terribly difficult situation for Cyprus and the euro. If the levy is not passed, the tiny yet troubled nation risks not receiving the bailout it desperately needs to save its insolvent banking sector. However, if the levy is passed, it will be a blow to confidence in Europe's banking sector and government.

We don't expect politicians to approve the levy very easily in the first round of voting, and if we are right about that, the uncertainty could keep the euro under pressure as the European Union confirms that Cyprus must stick to its goal of raising EUR 5.8 billion through a deposit tax levy.

Optimists argue that this situation is unique to Cyprus, but we don't know how reassuring that is considering this would set a precedent for the entire region. What we do know is that the Cyprus bailout has set the tone for trading in an extremely data- and event-risk-heavy week by rekindling the fear of a Eurozone debt contagion.

At bare minimum, there could be a capital flight out of European banks and slower long-term refinancing operation (LTRO) repayments on the fear of liquidity problems. Unless Cyprus completely scraps the deal, we can't see how some depositors won't reconsider their investments in Europe.

As a result, we expect the EURUSD to remain under pressure and investors to overlook any improvements in economic data. The Eurozone and German ZEW surveys are scheduled for release on Tuesday, and a minor deterioration is expected. If investor confidence weakens, it could compound the losses in the EURUSD, and even if confidence improves, it may not lend much support to the currency, as economists could be quick to say that the Cyprus bailout could change how investors feel about investing in the Eurozone.

See also: A “Monumentally Dangerous” Cyprus Bailout Scenario

US Dollar Outpaces Euro for Growth and Safety

Uncertainty in Europe has restored demand for the US dollar (USD). Not only is the greenback attractive for safe-haven purposes, but the recent improvements in US data also made the dollar attractive from a growth perspective.

While the decline in builder confidence (NAHB index) caught the market by surprise, stronger job growth last month should translate into stronger US economic activity. The Federal Reserve is meeting this week, and Fed Chairman Ben Bernanke will most likely acknowledge the latest improvements, but the fiasco in Cyprus renews concerns about Europe and could therefore temper the Fed's optimism.

See related: 4 Market Drivers Trumped by Tiny Cyprus

Also, while economic activity improved in the month of February, early signs for March have been disappointing, with the University of Michigan consumer confidence index dropping sharply and builder confidence declining on Monday.

Tuesday's housing starts and building permits will most likely surprise to the upside since these are February numbers and a rebound is expected after the decline in starts in January. While the potential for a government shutdown before the end of the month poses a risk to the US economy and the greenback, the US has been down this road before and survived.

If Cyprus' decision to tax depositors is finalized, it would be an historic event for the Eurozone and could undermine confidence in the entire region's banking sector. As result, we believe that the dollar will become more attractive than the euro in the near term, particularly if we hear more optimism than pessimism from the Fed and Chairman Bernanke.

GBP: Is the Safe-Haven Bid Back?

The strength of the British pound (GBP) against the euro suggests that investors may once again be looking to the sterling for safety. Despite grim economic data and the prospects for easier monetary policy, the safety of the UK banking system is not in question, and the pound is therefore attractive to some investors.

However, we’d caution traders from being overly bullish GBP because there are a number of potentially negative event risks this week that could drive the currency lower. Tuesday's consumer price report is important because inflation trends shape the central bank's monetary policy decisions, but after falling 0.5% in January, the 0.7% rebound that is expected is not abnormal. On an annualized basis, CPI is only expected to increase slightly, and core CPI is expected to fall.

The Bank of England (BoE) may be an inflation-fighting central bank, but weak demand has made growth the number-one concern. As a result, the producer and consumer price reports won't be as significant to sterling as Wednesday's BoE minutes, employment numbers, and the 2013 budget. The outcome of Wednesday's reports will help investors decide whether sterling is really worth holding for safe-haven purposes.

Aussie Holds Steady Ahead of RBA Minutes

Of all the major currencies, the Australian dollar (AUD) did the best job of holding onto its gains against the greenback today. This resilience is thanks, in part, to the anticipated release of the minutes from the last Reserve Bank of Australia (RBA) meeting.

Some may recall that the RBA left interest rates unchanged this month, and the AUDUSD soared over 100 pips in the 24 hours that followed. RBA Governor Glenn Stevens maintained a glass-half-full view of the economy, which was verified by last week's red-hot Australian employment numbers, and confirmation that the RBA is done easing could extend gains in the AUD.

The Canadian (CAD) and New Zealand dollar (NZD), on the other hand, fell victim to risk aversion despite better-than-expected economic data. Foreign investors bought 13.34 billion worth of Canadian-dollar-denominated assets in the month of January. While this was not the strongest increase in the past six months, it is still up there in terms of significant inflows. Canadian wholesale and manufacturing sales are due for release on Tuesday, and in New Zealand, consumer confidence declined in the first quarter, but service sector activity accelerated, pointing to hope for New Zealand's economy.

Bank of Japan (BoJ) Says “Sayonara” to Shirakawa

With no Japanese economic data released over the last 24 hours, the Japanese yen (JPY) traded purely on risk appetite. The desire for safety caused by the Cyprus bailout led investors to buy the yen against every other major currency counterpart. Demand for greenbacks, however, is still strong, especially with the Bank of Japan (BoJ) poised for another round of aggressive easing over the next six weeks.

BoJ Governor Masaaki Shirakawa will officially leave his post on Tuesday after serving as the head of Japan's central bank for the past five years. He will be holding his final press conference at 6:30 GMT on Tuesday. Haruhiko Kuroda will take over as BoJ Governor on Wednesday and will be joined in the central bank by deputy governors Kikuo Iwata and Hiroshi Nakaso, who will hold a press conference on Thursday.

Investors will be listening and keenly interested in any insights into the BoJ's upcoming plans for monetary policy. We know that Prime Minister Shinzo Abe chose his candidates based on their commitment to aggressive easing. The only question remaining is how quickly the new regime will act.

There are two BoJ meetings in April: one on April 4 and another on April 26. Most economists expect the BoJ to announce their new easing program after the late-April meeting, but there is a reasonable chance that the central bank could act sooner, as the minutes from the February meeting revealed some members supporting new measures on April 4. Either way, the BoJ is gearing up to do more, and that explains why USDJPY managed to recover so significantly from earlier lows.

By Kathy Lien of BK Asset Management

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