Cyprus seen raising risk to euro of new crisis flare-up

Cyprus's messy bailout has left the euro vulnerable to any new flare-up in the debt crisis, with aggressive monetary easing in Japan masking problems that would otherwise push the currency sharply lower.
Some analysts see the euro dropping to $1.20 or lower in a year's time and warn market participants, soothed by last year's European Central Bank pledge to preserve the euro and subsequent bond-buying plan, may not be fully pricing in the risks.
The euro bounced back to $1.31, from a 4 1/2-month low of $1.2740 hit last week in the wake of the Cyprus deal, helped by big gains against the yen after the Bank of Japan unveiled a $1.4 trillion stimulus plan on April 4.
Cyprus was the first euro zone bailout to hurt uninsured depositors, leaving questions over whether bank deposits are safe in indebted countries, such as Spain and Italy.
A new flare-up in the crisis could see depositors, fearing the Cyprus deal will become a template for the future, move money swiftly out of weaker peripheral banks.
"This would then create capital flight like we observed in 2011 and early 2012 (in Italy and later in Spain, where a bank rescue deal was agreed in mid-2012). This is new after Cyprus," said Ulrich Leuchtmann, head of FX research at Commerzbank.
"The OMT (ECB bond-buying program) is very good at preventing sovereign bond spreads from exploding but it is not geared to a privately-induced capital flight out of bank accounts and bonds."
Commerzbank has warned clients the increased risk of another crisis is not priced into the euro/dollar exchange rate.
DIVERTED BY JAPAN
A Reuters poll published on April 3 showed analysts cut their euro forecasts after the Cyprus bailout to a median $1.25 in 12 months. Ten of the 64 polled saw it falling to $1.20 or below.
But trends in options show that since the BOJ announced its bond-buying plan investors have scaled back bets on the euro falling, which built up after the Cyprus rescue was agreed in mid-March.
The BOJ's monetary easing steps have made the yen a more obvious sell than the euro, with traders speculating the euro will benefit from Japanese investors seeking higher yields.
Unlike central banks in Japan, the United States and the UK, the ECB is not printing money. Rather, its balance sheet is contracting, adding to the euro's appeal to some longer-term investors, such as central bank reserve managers.
"Currency wars elsewhere are masking inherent weakness in the euro system which is creating a false sense of security," said Nick Bullman, chairman of consultants CheckRisk, which advises on risk management on over $65 billion of assets.
Many analysts said the euro would do well in the short term after the BOJ action but that this may not last.
Steve Barrow, Standard Bank's head of G10 currency research argues the euro is being undermined in the longer term because various investors, now including depositors, are hit when a bailout occurs. He saw the euro at $1.20 by year-end.
Others, however, are reluctant to bet strongly against the euro as the ECB's OMT program makes it less likely that a crisis will spread from one country to another.
Just under a quarter of those polled by Reuters forecast the euro would rise to $1.30 or higher in 12 months time.
"$1.20 is not in my forecasts and it would have to gain a lot of steam to get there. But you can't rule anything out," said Jane Foley, senior currency strategist at Rabobank.
She said it would "take a very significant collapse in confidence" and investors were likely to wait and see how the ECB and EU politicians handle the next banking crisis.
Some analysts said the ECB's anti-crisis mechanism could not rule out a damaging flare-up in the debt crisis.
"The ECB's monetary framework has stopped the markets betting on the worst-case scenario, but they cannot prevent such a scenario from happening," said Lena Komileva, director of research consultancy G+ Economics.
CAPITAL FLOWS
Signs of crisis could prompt companies and private investors to shift deposits from the periphery into countries such as Germany. Others might switch to the Swiss franc and Danish crown, both of which are considered safe.
"Savvy investors, who tend to have the largest deposits, have been given a huge heads-up to be aware and to move money at the first sign of trouble," CheckRisk's Bullman said, adding the euro could drop as low as $1.15 by year-end.
Analysts said euro/Swiss franc, which hit a six-week low of 1.21305 francs on Monday, and euro zone bank shares .SX7P could indicate bank stress and capital flight.
"The investor who buys euro/Swiss franc tends to be the more pessimistic investor. It is a good indication of underlying crisis fears," Commerzbank's Leuchtmann said.