Are Markets Too Complacent Over Cyprus?

Cypriots line up at the ATM to withdraw their savings in the midst of the banking crisis in Nicosia, Cyprus.
Michelle Caruso-Cabrera | CNBC
Cypriots line up at the ATM to withdraw their savings in the midst of the banking crisis in Nicosia, Cyprus.

Financial markets have held up relatively well this week in the face of financial turmoil in the tiny European island of Cyprus, prompting some analysts to warn that investors are too complacent about the potential fallout from the crisis.

The European Union on Thursday gave Cyprus until Monday to raise the billions of euros the country needs to secure a bailout or face a collapse of its financial system that could mean Cyprus is forced to leave the euro zone. Ratings agency Standard & Poor's meanwhile cut Cyprus's credit rating one notch to CCC, pushing the rating deeper into junk territory.

(Read More: S&P Cuts Rating on Cyprus by One Notch to Triple-C)

And while jitters over Cyprus have weighed on financial markets this week, the selling in risk assets has not been as steep as feared. Stock markets in the U.S. and Europe are down about 1 percent this week, while Asian shares have shed about 2 percent.

"There is a degree of complacency and this is something we have been seeing for the past two months as investors become increasingly bullish," said Rob Aspin, head of equity investment at Standard Chartered. "One should anticipate some short-term weakness."

Yields on European peripheral government bonds, widely viewed as a gauge of investor sentiment in Europe, have also held up reasonably well.

Benchmark 10-year Italian bond yields dipped to 4.6 percent from 4.7 percent on Thursday. Yields on Spanish 10-year government bonds, which spiked above 5 percent earlier this week, are trading just below that level.

Analysts say the muted reaction to the developments in Cyprus demonstrates a worrying level of complacency in global markets, which have seen a surge in risk appetite since the start of the year.

(Read More: Russia Aid Not Looking Likely for Cyprus: Eurogroup Chief)

"The markets feel this [the Cyprus bailout reaction] will get pushed to sidelines like the Italian elections and Greece. This is a very real situation and we haven't yet fully priced in the damage it could do to the euro and to bonds as well," Michael Woolfolk, senior currency strategist at Bank of New York Mellon told CNBC Asia's "Squawk Box."

Watch Out Euro

Woolfolk said the euro, in particular, was vulnerable to any fallout from the financial crisis in Cyprus.

The euro, trading at about $1.2905 on Friday, has fallen about 4.3 percent from a high hit in mid-February.

(Read More: Allow Bad Cyprus Banks to Fail, Restructure: Banking Expert)

"Within a matter of one to two months we could go below $1.25 or even $1.20 by the summer," he said.

A move to those levels would imply a further loss of up to 7 percent for the euro, a currency that spent the second half of 2012 climbing higher on the back of easing concerns about the euro zone debt crisis.

Standard Chartered's Aspin said it was important to remember that Cyprus was a "unique case" and said a steep correction in equities or a spike in bond yields would not be driven by Cyprus alone and could come from other factors such as disappointment in corporate earnings.

(Read More: Cyprus Rescue Delayed by 'Russian Criminals': Analyst)

But given that risk assets have risen sharply and quickly in recent months, the chances of a sharp correction were high, other analysts said. U.S. shares are up 11 percent so far this year, while European shares have risen about 10 percent.

"We could easily see a correction at any time. The steepness of the rise in global markets means that we will remain vulnerable to it," Michael McCarthy, chief market strategist at CMC Markets, told CNBC on Thursday.