Market Commentary: Federal Constitutional Court's Ruling Backs Euro Bailout Fund - 09/13/2012

In Karlsruhe, German, the Federal Constitutional Court reject concerted efforts by numerous parties to block the eventual ratification of the European Stability Mechanism (ESM). This decision was expected, to date the court has never impeded European Integration, but has always maintained that Germany cannot accept unlimited liability for other EU member states. The €500bn scheme is vital to the ambitions of Angela Merkel and the majority of European leaders in stemming the rot in the European Union. The judges said the Bundestag can ratify the €190bn capped contribution to the ESM, but Berlin must include the caveat that it won’t exceed the cap without the court’s prior consent. The ratification of the ESM is vital because it’s needed to replace the European Financial Stability Facility (EFSF), which is expected to expire by mid-2013.

In a detailed summary of their decision, Chief Justice Andreas Vosskuhle said that the ESM must be banned from borrowing from the ECB, or depositing bonds as collateral. German rules ban the central bank from buying government bonds on the secondary market circumventing the capital markets in the funding of EU member states. Justice Vosskuhle went on to say, “The relevant factor for adherence to the principles of democracy is whether the Bundestag remains the place in which autonomous decisions on revenue and expenditure are made......No permanent mechanisms may be created under international treaties which are tantamount to accepting liability for decisions by the will of other states, above all if they entail consequences which are hard to calculate.”

The court’s decision was expected but the uncertainty up to that point continued to depress Bund yields somewhat, the resulting market moves were orderly (in current market environment) and logical, with Bunds dropping 100 ticks, this is an important technical level, if it breaks 139.20 area and holds the break, we could see a large sell off. The EUR continued its recent appreciation, with the €$ spot FX at 1.29 by mid afternoon London, it rallied as far as 1.2937 post the court’s decision, 1.30 is an obvious level to watch as we expect the euphoria surrounding the OMT and today’s decision to continue for a short period, if this is broken and holds we could see a move to 1.3250 in a short period of time. The OTC IRD markets reacted accordingly, with the € 2y, 5y and 10y swap yields jumping 3bps, 6bps and 8bps respectively as we write. European Indices were sanguine about the news from Karlsruhe, ending flat to up 1.4% by 4pm London.