How Cyprus bailout failure would hurt U.S. stocks

Negotiations for a financial rescue of Cyprus extended into late Sunday, leaving investors uncertain as to whether the small island-nation would agree to a bailout of its banking system that averts further turmoil in global markets.

Monday is the deadline for Cyprus to reach a deal on how it will raise 5.8 billion euros ($7.5 billion) so that it can receive a €10 billion rescue package from international creditors. The Cyprus economy could collapse without an agreement.

The European Central Bank said it would cut off emergency liquidity for Cyprus’s banks unless the country reaches an agreement to shore up its troubled financial sector. Follow streaming coverage of the Cyprus banking crisis.

The country took some steps in the right direction as the weekend began, passing legislation to impose capital controls and set up a “solidarity fund” to help raise the money. New reports suggest Cyprus was considering a 25% tax on savings accounts over 100,000 euros.   

 Failure to reach a deal for a bailout would mean that U.S. stocks “will open down pretty big on Monday,” said John Canally, chief market strategist at LPL Financial, who expects an agreement. “If we don’t get a deal done there, it does reintroduce some risk,” that could lift gold prices and the dollar, pull Treasury yields lower, and result in “anything associated with risk being sold off.”

The latest flare-up in the long-running European debt crisis comes as U.S. stocks reach record or near-record levels and as a number of analysts have raised their targets for the S&P 500 index SPX +0.72%  for the year. Gains in stocks have been supported by improving economic data and liquidity supplied by the Federal Reserve’s monetary stimulus measures.

Quincy Krosby, market strategist with Prudential Financial, said she’ll be monitoring credit-default swaps in Europe as well as yields on Spanish, Portuguese, Greek and Italian debt ahead of Monday’s deadline.

“If Europe is worried, the cost of credit-default swaps will rise, you’ll see sovereign yields rise,” and widening in the 10-year swap spread, “a picture of counterparty risk,” she said. “All of those will manifest before the [U.S.] markets open.”

The euro EURUSD +0.14%  on Friday rose as high as $1.3009 against the U.S. dollar, with investors appearing to anticipate a deal for Cyprus.Yet if that sentiment reverses, it would trigger “a savage, negative reaction” for the euro, said Richard Franulovich, chief currency strategist at Westpac Institutional Bank. A decline to the $1.27 to $1.28 level is possible and “it’ll keep dribbling lower and lower.”

The major concern for many investors is that if Cyprus’s banks become insolvent and can’t get help from the ECB, that could result in a run on the banks by depositors and possibly force Cyprus to exit the shared European currency.A subsequent drop in spending by consumers and businesses in Europe — at a time of already dismal growth expectations — and slower hiring could spill over to other economies worldwide, “and that’s where you get your contagion effect,” Canally said.

“We’re a week into this and we haven’t seen that yet, but that would be your worst-case scenario...that your average person in Spain and Italy and Portugal are worried about their bank deposits,” he said.

As long as the market believes that the Cyprus problem is “not terminal, then the market can continue in [it’s] trajectory,” said Krosby.

Investors will watch for any remarks about Cyprus and the European debt crisis by Fed Chairman Ben Bernanke when he speaks on a panel at the London School of Economics on Monday. Also Monday, William Dudley, president of the New York Federal Reserve and a voting member of the Fed’s interest-rate-setting committee, will speak in New York.

The trading week will be shortened by the Good Friday holiday.

U.S. equities rose on Friday, reflecting optimism about the Cyprus situation. The Dow Jones Industrial Average (TICKER:DJIA) jumped 91 points to 14,512.03, bouncing back from its biggest drop in nearly a month.

Sentiment on Friday was also helped by better-than-expected results from Nike Inc. NKE +11.06%  and Micron Technology Inc. MU +10.69%  as the new earnings season approaches. The lineup of quarterly results due next week is light, though BlackBerry BBRY -7.74% , will release fourth-quarter results on Thursday.

The S&P 500 index SPX +0.72%  and the Nasdaq Composite COMP +0.70%  each gained 0.7%, and Friday’s advances helped all the benchmark indexes narrow their losses for the week as Wall Street prepares to wrap up the first quarter.

“The market has become almost immune — whether it’s Washington, D.C. or the E.U. — to these deadlines,” said Krosby. “We’ve been conditioned to believe that in the 13th hour, either the issue is pushed to the next day or to the next week....and the market moves on,” she said. “So I don’t think things will change with Cyprus, at least next week.”

Krosby said she’ll also watch the performance in the futures market of shares in U.S. banks that are perceived to have a significant presence overseas.If the picture doesn’t look good for Cyprus, expect to see a climb in Wall Street’s so-called fear gauge, the CBOE Volatility Index VIX -3.00% , she said.

“But the real question becomes for American traders and investors is if Europe’s not worried about it, why should we be worried about it?”

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