CAC40 Divergence

Is Cyprus Risk Being Under Rated?

It’s Thursday evening and we’ve been watching the drama in Cyprus play out for nearly 1 week. There are 2 camps, debating Cyprus risk:

  • “Cyprus’ represents only a small proportion of the EU, throw them under the bus, no big deal, let’s get on with the bull market.”
  • And the, “this is just the tip of the iceberg, one domino ahead of reigniting Greece, Italy, and Spain, buy gold” camp.



CAC40 DivergenceOver the course of the week, European and American traders were mostly in sync and hanging out in the first camp, that changed today. The downward pressure has been greater in Europe, but today we started to see images of long lines at the cash machines, capital controls (limits on cash withdrawals) being put in place, growing protests, closed banks, and arm wrestling between the ECB and Cyprus politicians. These images are fresh reminders for the Greeks, Spanish and Italians.

Europe is getting nervous and as I’ve rambled about before I think Europe is going to be finding center stage very quickly now, by Tuesday of next week in fact.

It’s worth looking at the gold futures chart, which has shown a flight to safety all week. There’s a disconnect between the market reactions, which we could interpret as a slight increase in volatility or churn, and gold which is consistently moving higher. Buying gold has it’s own set of problems, but under macro pressure, it’s consistent and seeing it move higher is worth considering.

Gold Futures ChartSo if Gold is moving higher, and the S&P is churning what’s the VIX doing? I’d expect a significant jump in volatility, but it’s been as patient as the markets. The VIX is at 13.50 and just off 6 month lows. Have a look at the CBOE put/call ratios. Nothing there, surprising. Basically no reaction to the potential banking implosion/default of a European country.

So perhaps the apathy towards Cyprus is warranted, why worry about such a minor player? Maybe that’ll play out, but my feeling is that the market risk doesn’t have anything to do with the size of Cyprus. Confidence in the Europe is at risk. Draghi’s, “whatever it takes” is being called into question. Political (and financial) incompetence will shake market confidence, again. Eventually we might see a European Spring, enough might just be enough, and social unrest across Europe might move the VIX upward and the S&P downward.

The problem is that we’ve seen risk-on, risk-off in Europe for years now and eventually things settle down. I think this might be different because, Germany and the ECB are ready to throw Cyprus under the bus. A confidence backstop might be taken away, and if the ECB and Germany decide to stop funding banks because the island politicians won’t force austerity (a money grab), the game is over. Or maybe just starting to get fixed… In either case the risk seems undervalued from my desk.