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Why Isn't Euro Crashing on Cyprus Fears?

Why Isn't Euro Crashing on Cyprus Fears?

David Rodriguez, Head of Product
Why_Isnt_Euro_Crashing_on_Cyprus_Fears__body_Picture_1.png, Why Isn't Euro Crashing on Cyprus Fears?

Why Isn’t Euro Crashing on Cyprus Fears?

Fundamental Forecast for Euro: Neutral

For all the scaremongering over Cyprus, you would have expected the Euro to fall off of a cliff against the safe-haven US Dollar and British Pound. It didn’t. Why hasn’t the Euro fallen, and more importantly, can it continue to hold its ground given regional turmoil?

We’re left with many more questions than answers ahead of a potentially tumultuous Sunday market open, as the European Central Bank has made clear it will withhold Emergency Liquidity Assistance (ELA) from Tuesday if there is no Cypriot bailout in place. The threat is real: Cyprus has forced a bank holiday to prevent an unruly run on its banking system, and its banks will almost certainly need a lender to backstop the inevitable rush of withdrawals once banks reopen.

The prospect of deposit levies, capital controls, good bank/bad bank breakups, and a “solidarity fund” were all floated as potential solutions to the Cypriot crisis, but ultimate resolution remains to be seen. The most important question is whether any solution can gain traction before Tuesday and whether the Euro can survive true failure. It’s a remarkable feeling of déjà vu: we’ve been in very similar standoffs with the Greek crisis ahead of divisive elections. And yet the Euro has always pulled through as disaster is averted at the final moment. But what if this time is different?

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Cyprus represents a mere 0.2 percent of Euro Area GDP, but it’s clear that fallout from a Cypriot exit from the EMU could bring far more damage to regional economies than its size would suggest. It brings to mind the story of the Red Cliffs: a spark from the periphery could set fire to the broader core. It is in this sense that we think a breakdown in negotiations and a missed deadline would cause havoc across Euro pairs—particularly against the safe-haven US Dollar. Yet surprising EURUSD resilience above December highs of $1.2880 suggests that few traders expect the worst.

There’s no real sense of whether Cypriot and Troika officials will pull through in time. And as much as we dislike lying in wait, we see little choice but to react to developments in lieu of taking a proactive stance. Foreseeable market risk outside of Cyprus is relatively limited for EUR pairs, and it’s safe to say that ultimate resolution or lack thereof will likely be the biggest market-mover in FX.

From a technical perspective, it seems that the Euro’s hold of key lows may be the warning of a sharp move higher. The fundamental storyline could be fairly straightforward—a breakthrough in negotiations averts disaster yet again. Of course, the Cyprus situation has become so messy we honestly don’t know what such an outcome would involve.

If you have noreal reason to be bullish and many reasons to be bearish, the choice seems straightforward. Yet markets have a funny way of surprising even the most seasoned traders. In the words of one popular newsletter author, “we’re flat and nervous.” - DR

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