Investors tip German court approval for bailout fund
Financial market prices suggest investors expect Germany's constitutional court to back the new eurozone bailout fund this week, meaning that any glitch could unleash sharp moves in stocks, bonds and the euro.
Legal experts polled by Reuters unanimously predicted the court would throw out an attempt to block the European Stability Mechanism when it rules on Wednesday, though many expected it to impose far-reaching conditions.
Rejection of the ESM, a 700 billion euro fund, would hit policymakers' efforts to defuse the three-year-old euro zone debt crisis and ensure the survival of the common currency.
Analysts said a ruling in favour of the ESM was priced in, meaning the big risk was of a rejection.
Geoff Kendrick, a currency strategist at Nomura, gave a 95 percent likelihood of a positive outcome for the markets when the court decides on eurosceptics' complaints. However, he added: "If it goes badly it would be a disaster."
Markets have been buoyed by a plan detailed last week for the European Central Bank to buy potentially unlimited amounts of bonds of struggling eurozone countries. But the ECB would step in only if a state sought help from the bloc's rescue funds and accepted strict conditions.
German eurosceptics argue that treaties covering the ESM and a fiscal compact undermine parliament's constitutional right to decide on budget matters and could expose the country to unlimited liabilities.
If the court accepted their arguments and the ESM were blocked, the eurozone might lack the resources for future rescues, especially of big countries such as Spain and Italy.
Eurozone shares traded at six-month highs on Friday, Spanish 10-year bond yields fell below 6 percent for the first time since May and the euro hit its highest level against the dollar also since May, reflecting both the ECB's plan and renewed expectations of more monetary stimulus from the Federal Reserve after grim US jobs data.
Significantly, implied volatilities - a measure of expected price moves - on both the euro and European shares , fell further after dropping sharply on Thursday.
Kendrick said the euro would rise modestly in response to a positive outcome but fall sharply if it were negative. "There's a 95 per cent probability that it will go well and the euro will go up 20 points, and a 5 per cent probability it goes badly and the euro will fall by five big figures," he said.
A 20 point rise would keep the euro just above $US1.28, while a five big figure fall would push it to around $US1.23, a level last seen around mid August.
Fund managers, who typically adopt long-term investment strategies, were not changing their positioning or expecting any major upset from the court.
"Maybe the German constitutional court will have objections but we're expecting some sort of conditional approval," said Michiel Van Cranenburgh, a director at Paris-based Neuflize Private Assets, which manages around 3.5 billion euros chiefly invested in European equities.
"Whatever happens on September 12 can throw some sand in the wheels but it won't necessarily stop the rally. That's why we remain pretty much exposed right now, with long positions on the material and energy sectors, which are positioned to benefit from a higher inflation environment in the long term."
Neuflize had pared its bets on falls in the Euro STOXX 50 and S&P 500 since June to capture the ECB-fuelled equity rally, but Van Cranenburgh said the firm's fund managers were ready to take a more defensive positioning if the macroeconomic scenario deteriorated again.
According to the Reuters poll, the court could attach conditions to its approval, for example requiring parliamentary approval before the ESM was deployed.
Matthias Thiel, a capital markets strategist at M.M Warburg & CO, also expected a "yes, but" verdict from the court and believed that would leave markets broadly where they are, despite some possible short-term jitters.
"There might be a setback on the markets but I don't expect a generally different scenario after the German constitutional court ruling," Thiel said.
Hamburg-based Warburg, which has assets worth 38 billion euros under management, turned slightly overweight European equities, with a particular focus on peripheral countries, after the ECB's bond-buying announcement on Thursday to reflect the decreasing risk of a euro zone break-up.
A quarter of those polled said the court could order a referendum in Germany before further steps towards European integration.
"I can't quantify a (market) reaction, but a request for a new constitution to be ratified by a referendum would be a major upset," Holger Schmieding, chief economist at Berenberg Bank, said. "Now that we've had a nice rally, I would position myself cautiously for next week as the short-term risk probably outweighs the chances of further gains."
He said the imposition of lighter conditions would cause only a temporary pullback, with European stocks falling 1-2 percent until investors were reassured these hurdles could be overcome.
Morgan Stanley attaches a 40 per cent probability to an outright ESM rejection, a scenario it estimates could send the euro to lows against the dollar not seen since 2005, while eurozone shares would fall to June levels and the spread between peripheral and German bond yields would widen.
"Markets are not fully priced for a scenario where the ESM is rejected. It would come as a surprise and cause an issue, at least temporarily," Elga Bartsch, chief European economist at Morgan Stanley, said.
To protect against this scenario, the bank's strategists recommended buying one-, two- and three-month options to sell the euro against the dollar, taking advantage of the cheap option prices.