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Cyprus Bailout Crisis Slams Brakes on Risk-On

A trader looks at a display board showing information on the stock index, at the Madrid Stock Exchange in Madrid, Spain.
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A trader looks at a display board showing information on the stock index, at the Madrid Stock Exchange in Madrid, Spain.

Global markets traded lower and the euro hit a three-month low against the dollar on Monday as a weekend decision by the euro zone to force bank depositors in Cyprus to contribute towards a bailout provided a stark reality check for investors.

The losses were limited however, on reports the Cyprus government would put forward a new proposal on Monday to reduce the levy imposed on bank deposits.

European shares traded sharply lower with Spain's IBEX down 1.74 percent and Italy's MIB down 2 percent. Asian equity markets, took a sizable hit with Japan's Nikkei 225 and Australia's S&P/ASX 200 down 2.7 and 2.1 percent, respectively. The euro/dollar which fell to $1.2890 down from $1.3054 late in New York on Friday, recovered somewhat by mid-morning London time..

"Cyprus deposit haircut moves risk-on trade to backseat," Pimco's Bill Gross posted on Twitter late on Sunday. "Sell euro as well," he said.

Evan Lucas, market strategist at IG markets, added, "Expect the selloff to be hard today [Monday], barring any positive news coming out of Cyprus."

Lawmakers in Cyprus will hold an emergency session of parliament Monday to vote on the euro zone's decision to force bank depositors to contribute towards a 10 billion euro bailout. A levy will be placed on deposits of all sizes in return for financial aid and marks a radical departure from previous euro zone aid packages.

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Euro zone finance ministers want Cypriots with deposits of over 100,000 euros ($128,950) to fork out 9.9 percent of their savings while those with less than a hundred thousand euros will be hit with a 6.75 percent levy in order to raise 5.8 billion euros so that country will be eligible for an international bailout.

Investors are concerned that taxing depositors will set a dangerous precedent for the euro zone and ultimately risk runs on regional banks. The strategy may also provoke depositors in other debt-ridden nations to shift their money to "safer" European banks.

(Read More: Cyprus Bailout 'Disaster' Risks New Euro Crisis)

"The madness of this decision about Cyprus is unfathomable. We expect runs on Cypriot banks when they open on Tuesday [Monday being a bank holiday]. No sensible foreign depositor would continue to keep money in a banking system that just took nearly 10 percent of his deposit without any notice," David. Kotok, chairman and chief investment officer, Cumberland Advisors wrote in a note to clients.

"Europe has found a new way to shoot itself in the foot," he added.

Beware: Euro Weakness Ahead

The Cyprus bailout, which has reignited concerns over the stability of the euro zone, has cast a doubt over the outlook for the single currency.

"The first example of deposit hair-cuts during the entire euro crisis has potential to make depositors in Portugal, Spain and Italy nervous, despite likely assurances from policymakers," wrote Jens Nordvig, global head of G10 foreign-exchange strategy at Nomura.

The downside risk to euro-dollar and euro-Swiss franc have increased, Nordvig said, reiterating his forecast for the single currency to fall to 1.25 against the greenback by the third quarter.

(Read More: What You Need to Know About Cyprus)

Richard Yetsenga, head of global markets research, ANZ recommends selling the euro against the Swiss franc, Japanese yen, British pound, and U.S. dollar.

"This negative view could remain until greater clarification is given that Cyprus is a special case," he said.

Yetsenga advises investors keep an eye on peripheral bond spreads in Europe, which will be the earliest signs of contagion.

"If the peripheral bond spreads in Europe start to blow out that would indicate stress returning to the banking/sovereign relationship," he said.