The direction of worldwide stock markets rests on the negotiations taking place in the tiny nation of Cyprus right now. The country needs to raise $7.5 billion to qualify for a $13 billion bailout from the eurozone and the International Monetary Fund, and it has only a few hours left to do it. The ramifications will be widespread if Cyprus is the first country to leave the eurozone, a strong possibility right now.
Cyprus itself isn't a large economy, so a collapse wouldn't be devastating in and of itself, but it could set off a domino effect across Europe. The core problem is that the rescue package is centered on a tax on bank deposits, reportedly up to 40% for the wealthiest depositors in Cyprus. If taxes on bank deposits are an option for troubled countries to raise funds, it could cause depositors in countries such as Spain and Italy to race to the bank to pull out money, causing a run on the banks. It's this rapid withdrawal of funds that causes banks to collapse, and that's the risk for Cyprus and the rest of Europe.
The implications for investors in the U.S. can't be understated. Major markets have thus far ignored the Cyprus debacle, assuming a deal would be reached before conditions got too bad. Last week, the Dow Jones Industrial Average (DJINDICES:^DJI) and S&P 500 (SNPINDEX:^GSPC) were essentially flat even as negotiations between Cyprus and EU officials were getting tense. I don't think we'll see such a relaxed response if a deal isn't reached by the time markets open in the morning.
Investors should watch bank stocks particularly closely next week. Bank of America (NYSE:BAC) and JPMorgan Chase (NYSE:JPM) are in no danger of collapsing, but their counterparts in Europe could come under pressure if a run on banks begins. The global banking industry is highly interconnected, particularly at giant banks, and even a collapse in Cyprus could be bad for these two.
No one wants to see Cyprus collapse, but the bigger danger is that larger countries will follow the same path Cyprus is on. All of Europe is tired of bailouts and austerity, and there's growing backlash from those feeling economic pain from the cutbacks. Ironically, this backlash is what could bring Cyprus, and eventually Europe, to its knees.