Tiny Cyprus could have a big market impact
How Cyprus digs out of its fiscal hole – and how willing the European Union is to help – could set precedents for bailouts of other, larger nations. But traders don't expect its proposed tax on bank deposits to spread to other nations.
Investors had a subdued reaction Monday to the bailout chaos in Cyprus, but expect that to change significantly should policy makers stumble further.
What looked like a powerful sell-off instead turned into a session punctuated by a shrug and a collective breath-holding, with investors assuming that the initial plans to stop a potential sovereign debt hemorrhage would get scrapped.
"People are trying not to overreact," said Justin Wiggs, vice president of trading at Stifel Nicolas. "It's a big deal if the (original plan) does stick, but until we know, there's no definitive reason to sell except for taking some profits." (Read More: Cyprus Bank Tax Lit 'Two Sticks of Dynamite': El-Erian
Market participants have been waiting for weeks to see stocks take a break as the Standard & Poor's 500 has popped more than 9 percent higher in 2013.
The market has proven, though, to be resilient to scary headlines.
"When you're barking at the cusp of an all-time high, traders are looking for an excuse to sell down," said Jim Paulsen, chief market strategist at Wells Capital Management. "We're starting to understand that every bit of news is not a crisis."
A scare from the recent Italian elections sent the market into a brief tailspin from which it quickly recovered, and it looked like the weekend's Cyprus headlines might have the same temporary effect.
"At a minimum, Cyprus' pain is certainly providing clear evidence of what not to do in other countries," said Don Rissmiller, chief economist at Strategas. "The U.S. dollar is fulfilling its role as a reserve currency, though this probably comes through a few risk-off days to start."
(Read More: Cyprus Can't Put 'Genie Back in the Bottle': O'Neill)
Indeed, traders ran to the U.S. dollar against some currencies, but the greenback actually lagged against the euro and yen despite the geopolitical turmoil.
Overnight equity futures had indicated the market would fall 1 percent or more at the open, and the trading day did start off rough.
But the market regained its footing as hopes turned that European Union leaders would reconsider a plan that tapped savings accounts to pay for the bailout and raised fears of widespread bank runs.
"This weekend the news of course is of Cyprus and there shall be many who will argue that what happens in Cyprus should not…and some will argue cannot… have a material and long standing impact upon the US equity market," Dennis Gartman, author of the widely read Gartman Letter, wrote. "However, in the modern world that is simply not true." (Read More: 'Unfair, Dangerous' Cyprus Deal Whacks Rich Russians)
Those worries about global impact on a possibly precedent-setting decision for the future course of European debt rescues grew widespread.
The U.S. Treasury released a statement later in the day saying it would be monitoring the situation and hopes to see the bailout resolved in a "responsible and fair" manner.
"The economy of Cyprus is tiny...but far-reaching financial crises often have small beginnings and wars have been started over less," Julian Jessop, chief global economist at Capital Economics, said in a note to clients.
"What's more, if the rest of the EU is unwilling to cut a better deal for such a small economy at minimal cost, what chance is there for the bigger ones?"
Cyprus does present a unique case.
The island has developed a reputation for being a hotspot for international depositors looking for a place to hide funds, and the notion that some of that wealth would be taxed drew support from some quarters, including at the top levels of the International Monetary Fund. (Read More: Cyprus to Put Forward New Plan, Banks Stay Shut: Report
"Anyone paying attention wouldn't see this as the beginning of a worldwide trade," said Martin Leclerc, chief investment officer and portfolio manager at Barack Yard Advisors.
"I would be surprised if this model is repeated elsewhere. It's a Cyprus-specific issue."
In addition to the comparatively minuscule size of the Cyprus economy - about 0.2 percent of total euro zone gross domestic product - investors likely held to their beliefs that global central banks would continue to rush to plug any liquidity gaps.
The U.S. Federal Reserve has expanded its balance sheet past $3 trillion to backstop the financial system, while European Central Bank President Mario Draghi has pledged repeatedly to step in where necessary.
"The Fed is really engaged. The Fed cannot afford to see asset prices go down, and the economy is healing," Mohamed El-Erian, co-CEO at bond fund manager Pimco, told CNBC. "But there will come a time when we have to make that transition from assisted growth to genuine growth and there's a big question as to when and how we're going to do that."