Cyprus and Other Market Drivers

The main driver of the global capital markets has been the response to the weekend developments in Cyprus.  The knee-jerk reaction was to buy dollars and yen and sell most other currencies.  Equities markets tumbled, with the MSCI Asia-Pacific Index losing almost 2%.  European bourses gapped lower.   Core bond markets have rallied, with 10-year benchmark yields off 3-5 bp, while peripheral bond yields are sharply higher.

The immediate reaction in Asia was exaggerated and the market spent the Tokyo afternoon and the European morning retracing the initial moves.  The euro held key support near $1.2880 and recouped a cent by the middle of the European morning.  The key level to watch is $1.30, Friday's low, which is where the opening gap extends.

The dollar fell to just below JPY93.50 in the knee-jerk response, but has climbed steadily back to fill the opening gap in early Europe.  Sterling has fared well, giving rise to some talking about its re-found safe haven status.  Sterling briefly traded below Friday's lows, but half above $1.5060 and recovered a cent to trade near the pre-weekend high (~$1.5175).  The dollar-bloc was sold off, with the Australian dollar hit the hardest initially, but they have all stabilized around a third of a cent lower.  That is generally the pattern with the other major and emerging market currencies. 


In Cyprus, parliament is expected to vote, starting around 14:00 GMT (10:00 EDT) on a new proposal that will have a more progressive tax on depositors.  Instead of taking 6.75% from the first 100k euros, the rate may fall to 3%.  On deposits up to 500k, a 10% tax may be charged and in excess of 500k euros, 15% may be taken.  This modification is likely to prove sufficient to get parliamentary support.  Local press reports indicate that today's planned bank holiday will carry over tomorrow as well.

The deterioration of a large Cyprus bank had prompted the ECB to threaten to cut off access to ELA (emergency lending assistance provided by the national central bank at their risk, but with the permission of the ECB).  This would have set off a cascading sent of events that would have realistically led to the collapse of the entire banking system in Cyprus and left the government facing 30 bln euro bill to cover the depositors, which it could not afford.  Although Germany balked at keeping large depositors whole, reports indicate it was the ECB, EU and Cyprus itself that insisted on taking from small depositors as well.  The IMF, which had in recent weeks been signaling that depositors were vulnerable, also would have kept small depositors whole, according to reports.

The revised measures, however, continue to tax small depositors.  Indeed by calling it a tax, the deposit insurance does not get triggered.  The most biting criticism of the Cyprus package is about the principle not simply the amount of the tax on small depositors.   Nevertheless, press report suggest that there is not a run on other peripheral banks that some had feared as depositors across Europe would see Cyprus as a precedent.   As we have noted, there was precedent for Cyprus as well in Europe.  Italy imposed a one-off tax on all depositors (and other savings) to reduce its debt in order to join EMU in the first place. 

While the price action is dominated by the immediate reaction to the new from Cyprus, there were some positive developments in Italy.  Both chambers managed to elect speakers without much fanfare. It helped, of course, that some from the 5-Star Movement and Monti's allies turned in blank (or invalid) ballots.  In the Senate, the country's top Mafia prosecutor, Grasso will be the speaker of the Senate.  In the Chamber of Deputies, Laura Boldrini, a journalist and former spokesperson for the UN refugee program will be the new speaker.  We continue to expect that a government will be cobbled together on a limited agenda that will include selecting a new president, electoral reform and some pro-growth measures.  The tightening of credit conditions in Italy, which is choking many businesses will also have to be addressed before the new government.

Another observation worth of consideration is that Grillo may have helped launch a movement, but he, a 60-something millionaire who has been found guilty of involuntary manslaughter is an unlikely leader of a political party.  A party's discipline is enforced by punishing one's enemies and rewarding one's friends and Grillo's inability to do so means, his control over those that ran under his banner is not clear.   We have argued that as the 5-Star Movement addresses specific issues with finite choices it will become less cohesive.

The UK commands attention this week.  Tuesday's CPI is a warm up before the midweek flurry of the employment report, BOE minutes and Chancellor Osborne's budget.   We know that the BOE to did not resume the gilt purchase program, but we don't know the vote.  We suspect that Governor King was again joined by Fisher and Miles, as he was in February, in favor of new gilt purchases.  If a fourth member joined, the market will conclude the move will likely take place in April.  Some observers suspect that given the poor data, the IMF and Lib Dem calls to ease up on the austerity drive will get the Tory government to capitulate.  We think this is a mis-reading of UK politics and does not appreciate the political capital the Cameron government has invested in its current policies.   The UK will continue to pursue a course of tight fiscal policy and loose monetary policy.

The FOMC meets this week and the Fed will update its forecasts.   The recent string of US economic data confirms our belief that the world's largest economy will prove resilient to the tax increases and spending cuts implemented here in Q1.  The housing market continues its gradual recovery.  Weekly initial jobless claims, one of the best high frequency metrics of the economy (and stock market), have fallen to five year lows.  Industrial production rose 0.7% in Feb, led by a 0.8% rise in factory output.  Retail sales posted its largest five in months in Feb and the GDP measure rose 0.4% after increasing by 0.3% in Jan.    Nevertheless, we expect the FOMC to continue to buy $85 bln of long-term securities a month.  While there may be a dissent, we see the leadership and the majority still committed to QE.  Evaluation of the operation and the exit strategy of course will be discussed, but we do not expect the purchases to be tapered off until late in the year at the earliest.

The new BOJ management team takes office this week and an emergency meeting can be called for late in the week, though if it is to come, we suspect next week is more likely.  Governor Kuroda may want gain the initiative by meeting earlier, even though on substantive grounds a week or two one way or the other does not make much of a difference.  He does appear to have lost an element of surprise as it seems that buying more long-term government bonds is widely expected.  There does not seem to be any concrete ideas of how much he will purchase in total or per month, so there is an element of uncertainty still.
 Separately, over the weekend Prime Minister Abe used some of his political capital to indicate that Japan was going to join the Trans-Pacific Partnership (trade bloc) over the objections of some of his (powerful) supporters in the agriculture sector and some industries.  To the extent that the TPP leads to some restructuring of the Japanese economy, it may be consistent with Abe's economic strategy.  His public support ratings are high and the LDP are in a good position heading into the upper house elections late in Q2.