Bond Traders Read Clear Message from ECB Ruling: ‘Watch Out’

(Bloomberg) -- A critical German court ruling on the European Central Bank's half-decade of quantitative easing is worrying the likes of Aberdeen Standard Investments and UBS Group AG.

They're concerned of a potential knock-on effect on the central bank's latest stimulus to counter the coronavirus -- the Pandemic Emergency Purchase Program -- that has served as a backstop to the euro zone's most fragile bond markets in recent weeks.

Europe's debt and the euro fell on Wednesday, adding to the jolt lower Tuesday after the constitutional court gave the ECB three months to show how its first QE program is in line with the law. It comes down to what constitutes “monetary financing,” effectively the subsidizing of government spending by central banks.

While the original public sector QE program has strict limits to avoid that, such as how much of each nation's debt it buys, most of those do not apply to the emergency buying under the so-called PEPP. The ECB may now have to be more careful how it buys debt.

“In their assessment the 33% bond issue limit, capital key and minimum credit ratings are all important to avoid monetary financing,” said Patrick O'Donnell, a money manager at Aberdeen Standard Investments. “The problem is that these have all been relaxed for PEPP and the market is demanding a significant upscaling of it.”

Still, any legal challenge to the current program could be a while coming, and potentially drag on until after the coronavirus pandemic has come to a close. The case against the original QE program has already been ongoing for around five years.

The ECB responded to the court ruling by pledging to continue doing everything necessary to revive inflation, while pointedly remarking that the top European Court has previously said quantitative easing is legal.

The constitutional court indicated that after the three months lapse, the German central bank may have to sell its holdings of bonds, which would add to a deluge of debt supply as governments combat the coronavirus.

Aberdeen Standard's O'Donnell is not taking any chances, with an underweight position on bonds from France, Italy and Spain -- the nations that have a heavy reliance on the ECB's asset-purchase programs. All three economies are threatening to contract as much as 10% this year, blowing out fiscal deficits and requiring more borrowing in debt markets.

While the 750-billion-euro ($812 billion) pandemic program is set to snap up a lot of that, Citigroup Inc. expects it to run out by mid-October. It estimates the ECB bought nearly 40 billion euros of Italian bonds in April alone. Market hopes for an increase could now face some resistance, said Christoph Rieger, head of fixed-rate strategy at Commerzbank AG.

ECB Surveillance

The ruling also undermines ECB President Christine Lagarde's commitment to do everything necessary to keep the euro area intact, according to asset manager Candriam.

“This strongly weakens the ‘whatever it takes,” said Florence Pisani, global head of economic research at Candriam. “In short, this is pretty bad news for Europe.”

For UBS, it could begin to affect the ECB's buying strategy now. Any purchases above the so-called capital key, which weights buying according to the size of a country's economy and population, will likely have been done in shorter-dated bonds. The decision by the German court may mean support for that segment of the market dries up, it says.

Italy's two-year bonds took the biggest hit from the court ruling, with yields rising 20 basis points over the past two days. French two-year debt also slumped Wednesday.

“This implicitly means ‘watch out for those limits,'” said Jaime Costero, a rates strategist at UBS. “It delivered a clear message: do not be so soft, we are watching out you do not deviate from the capital key.”

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