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Kass: Cyprus Blight Could Spread

Regardless of those assurances, concerns will rise regarding less bank bondholder protection as well as fears of more deposit seizures. Importantly, the European banking industry's interconnected and wholesale-dependent funding base exposes the region to heightened risk of contagion.

Below are some other observations that support my view that global stock markets could sell off (a garden-variety correction) on the news that one of the smallest countries in the EU adopted a confiscatory policy toward bank deposits as a means of solution to its continuing crisis:

History Provides a Lesson

Financial history shows that small events in the international scene can pose a threat to much larger markets as they sometimes trigger a knock-on effect and a potentially violent response to a broader and more unstable (but associated) situation.

For example, the Asian financial crisis in mid-1997 started in Thailand with the collapse of the Thai baht after the Thai government was forced to float the baht and cut its peg to the U.S. dollar. This tiny country raised fears of a worldwide economic meltdown due to a possible financial contagion in Asia. As the crisis spread, most of Southeast Asia and Japan experienced weakened currencies, sharp drops in local stock markets and in property prices. Another example was the Lehman Brothers bankruptcy in 2008, a company with only 26,000 employees.

EU Dysfunction Underscored

Cyprus is a small, almost irrelevant country in the global economic and financial scheme, with a bit more than 1.1 million people and with GDP of only $24 billion. The key issue, however, as is the case with every small event that turns into a larger event, is that the solution aimed at addressing Cyprus's debt load that was hatched from EU authorities (read: Germany and northern Europe) uncovers continued eurozone dysfunction.

After the ECB successfully reduced the perception of tail risk by its intention to buy weak countries' sovereign debt through the OMT, the endorsement of the confiscation of Cyprus bank deposits raises the specter of another bout of contagion to depositors in Italy, Portugal and Spain. In essence, tail risk in the EU has now been lifted again.

There Are Unintended Consequences

It is widely acknowledged that many rich Russians (even Putin is rumored) have hidden and laundered money in Cyprus banks. It will be interesting to see if those Russian depositors have more muscle than the Europeans think. Could Russian energy exports to Germany become a policy weapon aimed to mitigate the pain felt by Russian depositors either overtly or underhandedly?

As well, with the hidden weapon of wealth confiscation exposed, once it has been used, who the hell will trust you that it won't be used again? It isn't the confiscation of Cypriot bank deposits that is the trigger that can shake the structure; it's the fear that every depositor in every bank in every shaky European country will feel the fear of the mother of all bank runs.

Market Receives Cyprus News in an Overbought State

As I discuss in Alan Abelson's Barron's column over the weekend, the Cyprus news comes in the face of an overbought market that has begun to display signs of a weakening foundation (rising bullish investor sentiment, a dwindling number of new highs on the NYSE, current price levels at marked distance above moving averages and even in the recognition/discovery of stocks by celebrities such Mila Kunis).

Impact on the Global Bull Market

Could the Cyprus news be a game changer for the U.S. stock market and bring a whoosh lower? Probably not. To date, as Freddy Mercury sang (see above), "nothing really matters" (or has mattered) in the central-bank-aided global bull market. Markets have been quick to dismiss serious financial and economic issues in Greece, Portugal, Spain and Italy. (Though these days I have preferred the words of "Acid Queen" Grace Slick or of Zero Hedge's Tyler Durden; see below!)

When logic and proportion
Have fallen sloppy dead
And the White Knight is talking backwards
And the Red Queen's "Off with her head!"
Remember what the doormouse said
"Feed your head!
Feed your head!"

-- Jefferson Airplane, "White Rabbit"

By tomorrow or early Monday, the EU will attempt to calm and reassure the markets, and the ECB will likely provide liquidity to the banks in Cyprus (which will no doubt see a run on deposits this week) in an attempt to prevent a broadening contagion. But this weekend's news will likely bring on the first meaningful correction of 2013, as the tail risks of Europe have increased in Friday night's unprecedented actions in Cyprus.

This is a breach of fundamental property rights, dictated to a small country by foreign powers, and it must make every bank depositor in Europe shiver. If you can do this once, you can do it again. Depositors in other prospective bailout countries must be running scared -- is it safe to keep money in an Italian, Spanish or Greek bank any more? This is a major, major game changer and the fallout will be with us for a long time to come.

-- "Saxo Bank CEO: 'This Is Full-Blown Socialism And I Still Can't Believe It Happened'," Zero Hedge

Based on conversations I have had with people who trade EU government debt and who are much more knowledgeable than me about Europe, it will take a few days to figure out how destabilizing the news will be on world markets.

The consensus of my contacts on the bond and stock market ramifications of the Cyprus news is quite negative -- namely, that it will not quickly blow over and has the potential to be a "Lehman moment" for Europe. They are generally more fearful than I (as perhaps I have grown accustomed and have become more sensitive to the fact that negative news has been readily dismissed in recent months by the global markets). So I would temper their more dire expectations, though I am open to the idea that in the intermediate term this news could hasten a garden-variety correction in the U.S. stock market.

My guess would be that over the very near term:

  • European stocks (taking the brunt of the impact) will fall by 3% to 4%;
  • the S&P 500 will drop by 1.5% to 2.0%;
  • the yield on the 30-year U.S. bond will move to 3.05% to 3.10% (a decline of 10 to 15 basis points);
  • yields on Italian and Spanish 10-year notes will climb by 10 to 15 basis points; and
  • the euro will fall 1.5%, to about 1.2875 against the U.S. dollar.

Winners: The beneficiaries of the Cyprus news are likely to be the U.S. dollar, Swiss franc, gold and U.S. Treasuries (higher in price, lower in yield).

Losers: The losers of the Cyprus news are likely to be the euro, European stocks and U.S. stocks. The debt and bank stocks of Italy, Spain and Portugal are likely to feel the most pain.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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