Cyprus – A Tempest In a Teapot?

News of Cyprus’s plans to loot deposit accounts has, not surprisingly, shaken markets and left many wondering whether this could mark the end of the current equity market rally. While we understand the concern, we believe this will only slow down – not derail – the “Great Rotation” from bonds to equities that we have been seeing in markets.
There are two main reasons for this. First, if the EU supports this emergency “levy” on bank deposits, they will surely emphasise that this is another “one time only” policy – not unlike the Greek bailout. They will have to be explicit about this – if only to prevent immediate bank runs in other teetering European economies.

Second, and perhaps more importantly, German elections are coming up in September and politicians cannot afford to spend the next few months in full crisis mode. Since the inception of the Euro Debt Crisis, German politicians have been toeing the line between keeping the EMU afloat and keeping their electorate satisfied that the Germans are not going to spend their hard-earned money endlessly bailing out their lazy neighbours to the south. While in public German politicians may use this crisis to reiterate their unwillingness to come to the rescue every time, behind closed doors they will be doing whatever it takes to put this episode behind them as soon as possible.

Even though Cyprus’s bank assets dwarf the size of its economy, the EU can handle the crisis in Cyprus and once again kick the can down the road, leaving room for this current rally to continue. The question is what course Germany plots following its elections, and how long bond investors will show patience to the real sick man of Europe – France.