Italy Bonds Slide on Risk Ruling on ECB’s QE Opens Pandora’s Box

(Bloomberg) -- Italian bonds dropped the most in the euro zone after a wrist slap given to the European Central Bank by the German constitutional court over its quantitative-easing program led traders to wonder if other debt-buying programs may be challenged.

The yield on 10-year bonds jumped as much as 17 basis points, widening the gap with their German counterparts -- a gauge of risk -- to 250 basis points. And the euro was among the biggest decliners in major currencies, with traders adding to their short positions, betting it will fall further.

Germany’s top judges gave the ECB three months to fix its 2.7 trillion-euro ($2.95 trillion) public sector purchase program (PSPP), after a seven-to-one ruling stating that some parts of it aren’t backed by European Union treaties. The ECB has also started a Pandemic Emergency Purchase Programme (PEPP) to counter the impact of the coronavirus.

“It’s my understanding that it doesn’t apply to PEPP, but if this proves a serious challenge to PSPP, the same argument could be made in courts against PEPP,” said Antoine Bouvet, a senior rates strategist at ING Groep NV. “This is not the sort of doubt you want to instill in the market.”

The PEPP is a 750-billion-euro program that runs out at the end of the year. The ECB started the public sector purchase program in 2015, to buy assets on the secondary market.

“It looks like the euro zone is shooting itself in the foot,” said Lee Hardman, a currency analyst at MUFG, who sees the euro falling through March lows if this isn’t resolved in a market-friendly manner. “The risk of another euro-zone debt crisis would be significantly higher without ongoing support from the ECB. Those are the risks the market is weighing up in light of today’s decision.”

Not Anytime Soon

The euro fell 0.6% to $1.0845 as of 1:15 p.m. in London. Italy’s two-year bonds were the hardest hit, and saw yields jump as much as 20 basis points to 0.83% before paring the increase. Debt in the rest of Europe’s periphery also retreated, with the rate on Spanish and Portuguese benchmark securities rising at least four basis points.

Given the time it takes for such court rulings, the risk the ECB’s bond-buying programs will be curbed by other legal challenges in the immediate future is unlikely.

The market is selling off “due to what this ‘could’ mean for PEPP -- not today, but down the line (months/more likely years),” said Jordan Rochester, a currency strategist at Nomura International Plc.

The ECB’s controversial asset-purchase program has been a concern for the German court since 2015, when the case was filed.

Here’s what strategists said about the ruling:

Nomura International (Potentially big)

• “What matters in FX is that it causes uncertainty and with it we’ll likely see this move in EUR continue,” says Rochester
• “The Bundesbank is in a rough place. If in three-months’ time the court is not convinced, clearly PSPP could enter a transitional period and they buy less bunds”
• In FX, “we remain short and look for 1.06 in the month to come,” referring to euro-dollar

Danske Bank (GCC barks, not bites)

• “In practice, this means the purchase programmes can continue - both APP and PEPP, but ECB needs to ensure that this is temporary,” says strategist Piet Christiansen
• He adds that “‘PEPP is not up for trial - hence no impact on markets”
  • “I don’t think we should read too much” into the three-month deadline, he added, noting other central banks would still be able to buy bonds

Commerzbank (Edge taken out of ‘whatever it takes’)

• “The ECB now has to do some due diligence on ‘proportionality’ over next three months together with the Bundesbank and the Bundestag --but this should pose no problem,” says head of rates strategy Michael Leister
  • “The GCC is taking the edge out of “‘whatever it takes’”
• “Even for bunds it’s not positive to have the ECB potentially constrained”
• “It increases pressure on politicians to provide a common backstop if the ECB is (potentially) constrained”

ING (Could keep German yields low)

• “The knee-jerk market reaction should be a sell off in both core (e.g. bund) and peripheral (e.g. BTP) assets,” says Bouvet
• “But should this prove a more serious challenge to the ECB’s ability to carry out QE, then portfolio reallocation flow away from risk assets should keep German yields low, and widen spreads to other issuers”

Credit Agricole (It’s all bad for the euro)

• “While we doubt that the decision will stop the ECB from easing further, the monetary policy process could become more cumbersome,” says Valentin Marinov, head of G-10 FX research

“It underscores the difficulty faced by the euro-zone governments in their fight against Covid-19”

• “This much warrants cautiousness on the EUR outlook from here”
• “As the news keeps coming, it’s all bad for the euro I am afraid”

©2020 Bloomberg L.P.