Market Insider

Don't Count Cyprus Out of the Euro Just Yet: Traders

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Uncertainty about Cyprus set markets on edge, but they are far from pricing in the tiny country's exit from the euro.

A barrage of headlines and rumors about what's going on in Cyprus sent the euro to a four month low and sparked selling in commodities and stocks. Investors also dumped European stocks and peripheral bonds and moved into the safety of U.S. Treasurys and German bunds.

The Cypriot parliament, in a closely watched vote, rejected a controversial plan Tuesday evening that would have taxed bank deposits as part of a 10 billion euro bailout plan. The country's central bank warned that that the uncertainty and the plan could cause a run on banks if confidence was not restored. The banks were to be closed until Thursday.

(Read More: Will Cyprus Derail Draghi's Good Work?)

Playing Hardball on Cyprus

The parliament adjourned, and the DISY party, or the Cyprus Democratic Rally party, headed by President Nicos Anastasiades, issued an immediate plea that European Union countries not to try to push Cyprus from the euro zone. DISY members abstained from voting on the bill. The market's biggest fear is that Cyprus would leave the euro, spreading contagion across the euro zone. That would put pressure on the region's weakest links.

"It's an awfully small fish to kill the whale," said John Briggs, senior Treasury strategist at RBS.

U.S. stocks recovered some losses in afternoon trading after the Cypriot parliament vote, and finished off their lows for the day. Analysts said one concern is that the European Central Bank would withdraw liquidity if Cyprus does not come up with a plan.

The ECB Tuesday said it took note of the vote and remained committed to providing liquidity "as needed within the existing rules."

BNP currency strategist Vassilli Serebriakov expected the parliament to vote first no, then yes. "It's not clear what we'll get in the end," said Serebriakov. "We don't think they're going to go the route of rejecting any deal because that would cause the ECB to stop financing Cyprus banks, and Cyprus leaving the euro…clearly there's going to be more uncertainty before we get anywhere."

(Read More: 'Unfair, Dangerous' Cyprus Deal Whacks Rich Russians)

He said if there is a vote on a deal that is going to look like a haircut on deposits, that would create worry about contagion. "I don't think it's going to be the kind of collapse we'd have had last year," he said. "Our sense is they will get a deal done." He said he expects to see money leave Cypriot banks regardless.

Briggs expects another vote that would remove the tax on small depositors. "Until the new plan is clarified and voted on, I think the market's are going to be jittery. It's going to be uncertain and safe havens are going to be in favor," Briggs said. He also said the issues with Cyprus will be negative for other European asset classes. "My sense is in a few weeks we'll be past this."

In the meantime, the markets are moving on every headline and rumor. On Tuesday morning, there was a report that the finance minister resigned, but then Michael Sarris was said to have volunteered to resign and his resignation was rejected.

The EU and International Monetary Fund are demanding Cyprus raise 5.8 billion euros from depositors to fund the bailout of the financial sector. Markets were surprised by the weekend outcome.

"It caught everybody by surprise over the weekend," said Serbriakov. "I think the initial reaction was notable for the lack of it."

He said the market reaction has been muted by easy policies from global central banks, and also the markets do not have a big long euro position.

A large amount of the deposits in Cypriot banks were made by Russians, and Sarris was in Russia, looking to extend an existing 2.5 billion euro loan. But Dow Jones also reported that Sarris is going to propose a deal that would impose a 20 to 30 percent levy on Russian-held deposits in Cyprus, costing billions of euros. Cyprus, in exchange, would give Russia equity in Cyprus' future national gas company and other deals.

Russian investors would also be given control of the boards of Cyprus banks, the report said.

J.P. Morgan's Alex White wrote in a note that Sarris "will put a renewed series of proposals to whomever will meet with him (possibly junior officials). These may include the offer of further rights over Cypriot gas deposits in return for accepting an increased depositor haircut. It is not impossible that Russia agrees, but we believe it will be harder to get a deal than people may imagine. A deal with Russia could also lead to European objections."

"The Cypriot authorities will also be putting calls in to Berlin. We do not expect the Europeans to fold ...There is a constituency in Germany for having an example made of a non-conforming country," White wrote. He also said the risks of a negative outcome are "clearly material," and he is increasingly pessimistic "about the direction of travel."

(Read More: Gartman on Cyprus: 'Don't Mess With Russian Mafia')