Market Hits New High Despite Cyprus Standoff

Demonstrators protest the bank deposit tax plan outside the Cypriot parliament on Tuesday.
Simon Dawson | Bloomberg | Getty Images
Demonstrators protest the bank deposit tax plan outside the Cypriot parliament on Tuesday.

Even as the euro zone stands firm, markets have embraced the view that Cyprus will strike a deal, most likely with Russia, that will help it structure a bailout.

The euro rallied, helping lift risk assets globally and sending the Dow back into record territory. European stock markets; peripheral sovereign debt and some commodities, such as oil and copper, were also higher.

The markets have feared since the weekend that Cyprus would fail to shore up its banks, and therefore not receive a 10 billion euro bailout.That would have then hastened its exit from the euro, a move that could have spread contagion to the euro zone's other weak members.

"Pending news, it's maybe not as negative as people were expecting earlier in the week," said Marc Chandler, chief currency strategist at Brown Brothers Harriman. "I think the market is taking it very well."

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

The Cypriot parliament on Tuesday rejected an EU plan to put a levy on bank deposits, and the country is now looking for alternatives, including help from Russia. Russians are heavy investors in Cyprus, and they have a substantial amount deposited in Cypriot banks. Rumors, later denied, circulated that Russian investors were ready to buy Cyprus Popular Bank.

Cypriot officials were meeting at the Central Bank on Wednesday, and Finance Minister Michael Sarris was in Moscow looking for help. He was reported to have sought a €5 billion loan as well as an extension of an existing €2.5 billion loan.

"We had a very good first meeting, very constructive and very honest discussion," Sarris told CNBC in Moscow. "We underscored how difficult the situation is, and we will now continue our discussions to find a solution by which we hope we will be getting some support from Russia."

Asked whether this meant an extension to the existing loan, Sarris said: "No, we are looking at things beyond that."

(Read More: Russia-Cyprus Talks: More Than a Loan Deal?)

Chandler said another story driving the euro is talk of a behind-the-scenes deal being worked out, where the government of Cyprus would get €3 billion from a deal with Russia for some of its natural gas assets. But he said it's unclear how such a plan would work out. Cyprus Energy Minister George Lakkotrypis was also in Moscow for a tourism exhibition, but Reuters said his presence fueled talk of a deal involving Cyprus offshore gas reserves.

Market strategist Ed Yardeni, in a note, pointed to the unsubstantiated report earlier this week that Russian Gazprom offered to restructure the Cypriot banks in exchange for exploration rights for natural gas, but Gazprom has denied that it offered any such deal.

"The tax measure was supported by Germany's government," Yardeni wrote. "Lots of rich Russians would have to pay it, maybe even (President Vladimir) Putin. Russians aren't likely to passively take a hit on their deposits.Germans may be quietly reminded that they depend on gas supplies from Russia. My hunch is that a solution will be worked out soon that doesn't include a tax on depositors. This seems to be the initial reaction of the stock market as well."

German Chancellor Angela Merkel said Wednesday it was up to Cyprus to come up with an alternative proposal, and she said it would be fair to expect depositors with more than €100,000 to contribute to the bailout. She said Cyprus needs to shrink its banking sector.

"Difficult talks with Cyprus lie ahead of us," she said.

Ward McCarthy, chief financial economist at Jefferies, said the relief rally in risk assets also has to do with an initial overreaction, when markets sold off Monday. "There's no reason to be reassured on anything," he said. "My interpretation is the knee jerk action was that it was so out of left field, such a surprise. Now people have had a chance to think about it and put it in context."

McCarthy said the fact the Cypriot parliament opposed the levy on bank deposits was a positive for markets. "I think what is important here is this precedent of taxing deposits fails," McCarthy said. "That's precedent that's not in anybody's interest. You could have governments confiscating people's bank deposits everywhere. If it can happen there, it could happen anywhere.I would classify this as one of the most preposterous proposals I've ever encountered."

The bank levy scheme to raise €5.8 billion to shore up Cypriot banks was a criteria for the bailout by the EU and the International Monetary Fund. The European Central Bank had said it would withdraw liquidity if Cyprus did not adopt the plan, but it said late Tuesday that it was continuing to provide liquidity

Vassili Serebriakov, currency strategist at BNP Paribas, said a solution involving Russia would be the most ideal for Cyprus, since European member countries are not likely to bend on requirements for Cyprus, especially Germany

"The rhetoric is going to be tough for sure," said Serebriakov. "There needs to be a solution. I still think getting Russia involved more is probably politically and economically one of the better solutions. I don't think there are any perfect solutions. It think there's going to be damage done either way."

Cypriot banks are closed through the end of the week. "I think whatever we're going to get as a solution in Cyprus, the authorities will need to impose capital controls because there's going to be moves to pull funds out either way," he said.

(Read More: 'We Will Be Slaves for Russia': Cypriots Warn)