Euro-to-Dollar Downside Grows after German Constitutional Court Adds to Woe with ECB QE Ruling

Image © Alfred Yaghobzadeh, European Commission Audiovisual Services

- EUR/USD spot at time of writing: 1.0851
- Bank transfer rates (indicative): 1.0513-1.0589
- FX specialist rates (indicative): 1.0731-1.0796 >> More information

The Euro-to-Dollar rate slumped on Tuesday and expectations were mounting for more downside on the road ahead after a court ruling stoked uncertainty about whether Germany will be able to continue participating in the European Central Bank (ECB) quantitative easing (QE) programme.  

The constitutional court of Germany has decisively scuppered what had been a tentative improvement in the market's appetite for the Euro, which also weakened in advance of the decision on Monday. This was after rising 1.39% last week, with much of that gain coming after the ECB suggested it will stand behind 'periphery' bond markets if falling prices and rising yields scupper its efforts to support the financially vulnerable economies of Southern Europe. 

"While the GCC’s rulings on “proportionality” and “prohibition of monetary financing” do not directly apply to the “Pandemic Emergency Purchase Programme” (PEPP), the verdict somewhat curtails the ECB’s flexible use of PEPP," Holger Schmieding, chief economist at Berenberg

Germany's top court sought further information Tuesday about the manner in which QE is being carried out, to clarify its conformity with German law, and has given the Bundesbank a viable road to withdrawing its participation in QE if conformity with German law isn't confirmed within three months. 

This QE programme is however, increasingly the only monetary policy game in the Eurozone town given the ECB's main interest rates have been cut so far.

"The German constitutional court ruling on the illegality of some of the ECB asset purchase programme actions has sparked fresh EU existential woes this morning and are weighing on the euro and risk appetite more broadly," says John Hardy, head of FX strategy at Saxo Bank. "The ECB is increasingly operating as a force for mutualization for risk by beginning to violate the principles of purchases not based on the capital key (according to size of GDP of member countries), while there is no EU finance ministry or mutual debt. Hard to tell whether this is the spark for dramatic new pressure on the EU once again, but it is certainly putting the EU politicians’ feet to the fire."

Above: Euro-to-Dollar rate shown at daily intervals.

Unless the ECB demonstrates within the next three months that its actions are proportionate, Bundesbank participation in Eurozone policy operations like QE could cease. Given that QE is increasingly the ECB's only monetary policy tool, non-participation could be said to bring about, in a roundabout way, something like a half-in and half-out style of Eurozone exit for Germany. The country has long been the largest underwriter of the single currency. 

"The German Constitutional Court did not reject the ECB’s bond purchases directly, but gave the ECB 3 months to provide more clarifications, or the Bundesbank is out. This means more near-term pressure for Italian bonds and EUR assets in general," says Jan von Gerich, an economist at Nordea Markets. 

The verdict addresses the legality of QE generally and is most relevant for the ECB's long-standing programme of bond buying, which has become its main monetary policy transmission mechanism because interest rates are widely believed to have already been cut as low as they can be.

The ruling doesn't address the pandemic emergency purchase programme unveiled in March but does throw a cloak of uncertainty over the ECB's general response to crises at a time when it's increasingly the only thing standing between the single currency and another debt crisis.

"What matters in FX is that it causes uncertainty and with it we'll likely see this move in EUR continue," says Jordan Rochester, a strategist at Nomura. "We've been pushing short EUR/USD for a few weeks now, net-long EURs are one of the more "crowded" trades in G10 FX positioning. We remain short and look for 1.06 in the month to come."

The ECB has proven itself again to be the only crutch that fiscally challenged and financially fragile countries Southern countries can lean on when the going gets tough, and particularly in the coronavirus crisis. Countries like Italy are denied a proper and supportive currency depreciation by the North European trade surplusses that produce more positive Euro-to-Dollar flows than otherwise would prevail, while years of budget deficits and self-flagellation at the instigation of European treaties have done little to improve balance sheets but continued to further enfeeble 'periphery' economies. 

Above: Euro-to-Dollar rate shown at weekly intervals.

"While the Eurozone’s huge current account surplus may continue to lend support, sentiment in the EUR will be eroded if politics turn sour on the issue of fiscal coherence within the region. An important aspect of this is the financing of Italian debt. The presence of the ECB as a backdrop is an important and necessary stabiliser in the Italian BTP market. If confidence is shaken this is likely to feed through into the EUR," says Jane Foley, a senior FX strategist at Rabobank. "We see the risk of another dip towards EUR/USD 1.08 in the coming weeks, and cannot rule out a drop towards the 1.05 area this summer." 

Tuesday's ruling comes amid a row between Southern Europe and the trade surplus countries of the centre and North including Germany over the appropriate fiscal response to the crisis. With debt sustainability and rebellious bond markets in mind Southern European countries have pursued a mutualised funding capacity that would provide grants to troubled member states, but some countries in the centre and the north have opposed the plans because of political objections to enhanced fiscal burden sharing. 

"The ball is now in the ECB’s court to convince German courts that purchases will converge to the capital key once this is over. If German courts reject the ECB’s response, the ECB can still continue its purchases but the EUR would take a hit considering the blow to the monetary union. For now that shouldn’t be the base case as we’ve been here before (remember the initial German opposition to QE?)," says Bipan Rai, North American head of FX strategy at CIBC Capital Markets. " A break of the 1.0800 area in EUR/USD will have the pair testing April 24 lows of 1.0727."

The row has prevented a comprehensive European fiscal response to the coronavirus crisis for months now while stoking the fires of Euroscepticism in Italy and, potentially, other places too. At a minimum, this could mean it takes longer than otherwise would be the case for some Eurozone economies to recovery from the coronavirus while weighing further on the single currency. 

Eurogroup finance ministers meet Thursday to discuss a recovery fund they've been tasked with designing, although even in the  event they're able to reach an agreement - which requires endorsement of the next multi-annual EU budget - the fund is not expected to be operational until January 2021. The meeting will come with signs that U.S.-China trade tensions are rising again, which were bearish for the Renminbi-correlated Euro and Eurozone economy last time out. 

"Leveraged money participation in EURUSD has thinned down noticeably in recent weeks. Still, it may take as much as 1) a deliberate weakening of the USD, 2) a major improvement in global trade issues or 3) another collapse in US yields to send the pair sustainably through 1.10," remarks Stephen Gallo, European head of FX strategy at BMO Capital Markets in a Monday note. 



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