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Cyprus a Game-Changer for the Euro

Monday, 18 Mar 2013 | 5:11 PM ET
Siegfried Layda | Photographer's Choice | Getty Images

The weekend bailout deal for Cyprus has ignited fears among bank depositors, and currency investors have the shivers as well.

Adarsh Sinha, head of Asia Pacific G10 FX strategy at Bank of America Merrill Lynch, said the pain is not over.

"The risk is clearly to the downside, even from here," he told CNBC.

Sinha said investors were not focused on the Cyprus negotiations, so some of the immediate reaction is just an expression of shock. "There's a lot of confusion among the clients that I've spoken to about what's going on in Cyprus," he said. "To be honest, it is a big surprise."

(Read More: How Europe Stumbled Into Scheme to Punish Cyprus Savers)

The real issue with this admittedly small bailout package "is the precedent it sets," Sinha said. Investors are less concerned about the impact on Cyprus specifically, and the fact that depositors in Cyprus banks will have to take haircuts, than about the possibility that similar deals may be struck in larger euro zone economies. The implications are potentially enormous if investors lose faith more broadly in the euro zone banking system.

Downside Risk for the Euro
Adarsh Sinha, Head of Asia Pacific G10 FX Strategy at BofA Merrill Lynch Global Research says the Cyprus bailout offer of levying bank deposits came as a surprise and he's bearish on the euro-dollar.

Investors have been essentially flat on the euro in recent days, according to Sinha. But in the wake of the Cyprus deal, the common currency is approaching its 200-day moving average, a key technical level. "If we go through that, then the market will start to sell the euro," Sinha said.

He doesn't expect the euro to collapse, he said, but added, "if you're an investor and you are flat euros, you have no choice but to go out and sell on the back of this news."

Jens Nordvig, global head of FX strategy at Nomura Securities, said the Cyprus deal "raises question marks around the improving trend in euro zone banking flows observed since August 2012." He doesn't expect big outflows from Cyprus banks specifically, but said, "the bigger issue is the indirect effect through tension in euro zone bond markets and potential deposit instability in the entire region."

Nordvig was already forecasting a lower euro before the Cyprus news broke, but he was holding out for a tick upward by the currency to enter a trade. Now he is using options to take a short position.

Kathy Lien, a managing director at BK Asset Management, says the Cyprus deal has major, and potentially serious, implications for the entire euro zone.

"Investors are shocked by Cyprus' bailout news as they should be since this would be the first time in euro zone history that depositors have taken a loss," she wrote in a note to clients. The deal may be modified, she said, but "the mere possibility that they will be taxed at all undermines the credibility of the entire banking system."

The strategists at Barclays Capital are somewhat less alarmed.

"We think the scope for contagion to other peripheral countries in terms of deposit outflows and sovereign debt is considerably more limited than before," they wrote in a note to clients. Still, they said, "the imposition of a levy on depositors is a material development that further erodes bondholder protection at European banks."

With the prospect of some sort of change to the bailout deal in the air, the BarCap strategists expect the uncertainty to continue weighing on "market confidence in general and on the EUR in particular."

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