There is nothing like the pain of real losses to impress a principle deeply into people’s psyches. In Cyprus (and likely in other similarly situated countries) a lesson is now clearer to more people and businesses than it has yet been.
The Euro-banking system cannot be trusted.
Below are our analysis and predictions.
We expect that many people and businesses in Cyprus will entrust only a minimum amount, for cash flow needs, to domestic banks. They will withdraw the rest once the government allows the banks to reopen.
This will further weaken banks that are probably already close to toppling. Further rumors will grow in fertile ground. It should not take very long for Cyprus to be drained of most of the Euros presently kept there. The banking system will be reduced to a living-dead zombie, assuming the government acts to prop it up (which would be par for the post-2008 crisis world). Without government-provided infusions, the banks will collapse sooner rather than later. Either way, they will be incapable of performing their function of intermediating savings and lending to productive enterprise.
The spiral will become vicious as Cyprus government bonds sell off, causing further losses to the Cyprus banks (who own those bonds). This will be happening as the banks are being drained of their liquid cash. This process will likely play out in other distressed Euro area periphery countries. We see no reason it should not also play out in non-Euro countries such as Hungary, which will face the additional problem of the collapse in the value of its currency. Cypriots will suffer as the Euro declines, but problems in Cyprus by themselves cannot cause the currency to collapse.
The question on everyone’s mind is what will these people buy when they sell Cyprus bank deposits? Clearly, much of it will go into other Euro area banks such as Germany. Those with small bank account balances will not be able to justify going into other currencies nor typically have the sophistication or knowledge to do it. We expect they will hold paper notes more than they had and if that is not sufficient then they can open an account at Deutsche Bank or another bank in a domicile they trust.
The “inflation = rising money supply” crowd may sell gold, thinking that Cyprus is causing the money supply to shrink, thus prices to fall, thus people won’t need an “inflation hedge”. That would be a big mistake.
While the dollar price of gold could go up or down in the short term (the initial response of the gold price to this news is to rise), the real and sustained response will be to rise.
Gold metal has no counterparty.
The real meaning of deflation is a forcible contraction of credit. The Quantity Theory of Money holds that as the quantity of money (credit, really) decreases, the remaining units should increase in value. The reality is that those who hold credit in a time of sudden defaults are risking total losses. Prior to now, depositors in Cyprus may not have realized this (or maybe they had plenty of evidence), but now they know. And so do depositors, bond holders, etc. in other countries. Why should they not hold some portion of their wealth in gold? Aside from the lack of default risk, there is also the lack of debasement.
Perhaps even more interesting than seeing what happens to the gold price will be seeing what happens to the gold basis. While this is not a prediction, we would expect to see a falling basis and rising cobasis. Readers can follow the basis weekly in the Last Contango Basis Report. This is a perfect opportunity for leveraged traders of futures to be out of sync with the reality on the ground in peripheral countries.
People trying to protect themselves from sudden death will not behave the way that the Quantity Theory of Money says they ought.
We think two other currencies will see inflows: the US dollar and gold, in that order. We would not expect silver to be bought as much as gold in this transition. For larger amounts, gold is the monetary metal of choice. Those with only small amounts may not be in a position to do much, as they need their balance for daily living expenses. We have been expecting the gold:silver ratio to rise, and this event will likely add fuel to this trend.
There could be a good blip in other non-Euro currencies. It certainly seems plausible that every multinational corporation doing business in Cyprus (or Hungary, etc.) would consider reallocating some of their cash balances out of the euro and into their domestic currencies. If CHF weren’t pegged to the euro at 1.20, it could go up on this news. As it is, GBP, NOK, RUB, and maybe CNY could go up against the euro as a direct result of Cyprus.
The biggest gains of all paper currencies will be in USD. The US dollar, for those Europeans who want to get to a “safe haven”, will be the least unsafe. This will likely have the consequence of rising US Treasury bond prices / falling yields.
The question of the impact on the US stock market is more complex. In general, the question of why US stocks have been rising in a deteriorating real economy is a topic I intend to address in a separate paper (no, it’s not due to rising “money supply”!)
The short answer is that the inrush of capital being transferred out of Europe could drive up all dollar-denominated assets. There are two massive opposing forces. First, business conditions in Europe will turn down harder as a result of Cyprus. US based multinationals will earn fewer euros in Europe, and each of those euros will be worth less in terms of dollars. The combination could be a significant hit to S&P earnings.
Second, the credit contraction in Cyprus will impact credit in many other areas. Facing additional stress on their balance sheets, a variety of players from banks to hedge funds to insurers may decide to sell assets to pay off liabilities. An environment of contracting credit could be the perfect storm that begins a selloff period in equities.
One thing seems likely. The trading pattern that has persisted for a seeming eternity now may end, to be replaced with a different one. This new pattern will likely contain at least some of the elements presented above: rising dollar, rising Treasury bond, rising gold, rising gold:silver ratio, credit crisis contagion, deteriorating economies, falling corporate profits, and maybe falling stock prices.
We live in interesting times, of that there is no doubt.