Yet another European Union (EU) crisis flare-up, this time in Cyprus, is roiling global financial markets again as European finance ministers, in cahoots with the Cyprus government, conspired last weekend to pull off an unprecedented bank heist.
Much has already been written about the great Cyprus bank robbery. So I won’t get into the details, but it’s clear that investors now have more uncertainty to worry about.
However, there are a few barometers of market volatility you should be watching closely right now; they can help you gauge whether risks will continue to rise and reverse the upside trend in global stocks …
First, watch how global currencies respond …
|Currency trades can reveal where confidence has fallen.|
The global Foreign Exchange Market is the world’s largest with trading volume of approximately $4 trillion a day. Movements in key currency pairs reflects changing interest rate conditions, growth prospects and investor sentiment around the world, and can often foreshadow sizeable moves in global stocks and bonds.
Even before the Cyprus bank job, the euro currency was under selling pressure as you can see in the graph below.
The euro has been under pressure all year, as I wrote about last month, recently falling to a three-month low against the buck.
But after the Cyprus news, when forex trading began Sunday evening (our time), the euro plunged the most in 14 months against the dollar! Mind you, the euro slid lower against most major currencies, as you might expect. But it even plunged 2.8 percent overnight against the beleaguered yen … a currency that is intentionally being manipulated lower by the Bank of Japan!
It would not surprise me to see the euro continue to slide lower against the buck, mainly for fundamental reasons, but if the euro keeps losing value against the yen … watch out!
I would interpret this as a big vote of NO confidence against the EU. After all, if the euro can’t even hold its value against a basket-case currency like the yen, it means more trouble ahead!
Second, monitor bank money flows …
Capital flowing OUT of a troubled market is a sure sign of trouble ahead as well-healed investors flee for safety. Sure enough, Cyprus was facing a bank run well ahead of this week’s hastily conceived bank holiday.
Over the three-months ending January 2013, private investors yanked 1.9 billion euros out of Cyprus bank deposits — with 1.04 billion in withdrawals in January alone!
EU money supply data is published (with a lag) by the European Central Bank. And it pays to keep an eye on where the money is flowing because it isn’t just Cyprus experiencing capital flight …
Portugal, Spain and Greece, among others, are also experiencing hefty bank withdrawals. In January deposits in Spain and Portugal shrank by 1.8 and 1.9 billion euro respectively. And savings in Italian banks plunged 30.7 billion euro!
Granted, uncertain election results in Italy also had an impact on withdrawals. But that’s just another reason for investors to be cautious about rising risks in Europe spilling over to global markets.
Third, watch for tightening EU financial conditions …
The Bloomberg European Financial Conditions Index (BFCIEU) combines real-time measures of credit spreads, money markets, bond markets and more into a single snapshot of overall financial conditions across the EU.
As shown in the graph below, when financial conditions are tightening — a sign of growing risk and volatility in markets — the index value declines, as it did in mid-2012 when Spain required a bailout.
As you can see, financial prospects in the U.S. and Europe were following diverging paths in recent weeks, even before the Cyprus bank heist. Financial conditions in the U.S. remain much stronger than in Europe, and neither index is anywhere near the lows of 2012.
But keep a watchful eye on the EU Financial Conditions Index, because if it starts to fall off a cliff and especially if the U.S. index follows, it’s a sure sign the crisis is spilling over and volatility is likely to rise, even for U.S. stocks.
Bottom line: No one can be sure how long the latest EU crisis in Cyprus will last. It could be resolved relatively quickly. After all, Cyprus’ economy is pretty small … about the size of Winston-Salem, NC. But the danger lies in the unintended consequences that could result.
Ratings firm Moody’s for example has already said this is: “a significant step toward limiting support for bank creditors across Europe.” Another wave of downgrades for European banks and countries could follow. Confidence in markets is a fragile commodity. And in the global information age, loss of investor confidence can quickly spread, infecting markets worldwide.