The talk in the market is still
‘Bout German high court overkill
While pundits debate
The bond program’s fate
The euro is heading downhill

Amid ongoing dreadful economic data, the top story continues to be the German Constitutional Court’s ruling on (rebuke of?) the ECB’s Public Sector Purchase Program, better known as QE. The issue that drew the court’s attention was whether the ECB’s actions to help support the Eurozone overall are eroding the sovereignty of its member states. Consider, if any of the bonds that are bought by the central banks default, it is the individual nations that will need to pay the cost out of their respective budgets. That means that the unelected officials at the ECB are making potential claims on sovereign nations’ finances, a place more rightly accorded to national legislatures. This is a serious issue, and a very valid point. (The same point has been made about Fed programs). However, despite the magnitude of the issues raised, the court gave the ECB just three months to respond, and if they are not satisfied with that response, they will bar the Bundesbank from participating in any further QE programs. And that, my friends, would be the end. The end of the euro, the end of the Eurozone, and quite possibly the end of the EU.

Remember, unlike the Fed, which actually executes its monetary policy decisions directly in the market, the ECB relies on each member nation’s central bank to enter the market and purchase the appropriate assets. So, the ECB’s balance sheet is really just a compilation of the balance sheets of all the national central banks. If the Bundesbank is prevented from implementing ECB policy on this score, given Germany’s status as the largest nation, and thus largest buyer in the program, the effectiveness of any further ECB programs would immediately be called into question, as would the legitimacy of the entire institution. This is the very definition of an existential threat to the single currency, and one that the market is now starting to consider more carefully. It is clearly the driving force behind the euro’s further decline this morning, down another 0.5% which makes 1.5% thus far in May. In fact, while we saw broad dollar weakness in April, as equity markets rallied and risk was embraced, the euro has now ceded all of those gains. And I assure you, if there is any doubt that the ECB will be able to answer the questions posed by the court, the euro will decline much further.

The euro is not the only instrument under pressure from this ruling, the entire European government bond market is falling today. Now, granted, the declines are not that sharp, but they are universal, with every member of the Eurozone seeing bond prices fall and yields tick higher. This certainly makes sense overall, as the ECB has been the buyer of (first and) last resort in government bond markets, and the idea that they may be prevented from acting in the future is a serious concern. Simply consider how much more debt all Eurozone nations are going to need to issue in order to pay for their fiscal programs. Across the entire Eurozone, forecasts now point to in excess of €1 trillion of new bonds this year, already larger than the ECB’s PEPP. And if there is a second wave of the virus, forcing a reclosing of economies with a longer period of lockdown, that number is only going to increase further. Without the ECB to absorb the bulk of that debt, yields in Eurozone debt will have much further to climb. The point is that this issue, which was initially seen as minor and technical, may actually be far more important than anything else. And while the odds are still with the ECB to continue with business as usual, the probability of a disruption is clearly non-zero.

Away from the technicalities of the German Constitutional Court, there is far less of interest in the markets overall. Equity markets are mixed, with gainers and losers in both the Asian session as well as Europe. US futures, at this time, are pointing higher, with all three indices looking toward 1% gains at the open. And the dollar is broadly, though not universally, higher.

Aside from the euro’s decline, we have also seen weakness in the pound (-0.4%) after the Construction PMI (the least impactful of the PMI measures) collapsed to a reading of 8.2, from last month’s dreadful 39.2. This merely reinforces what type of hit the UK economy is going to take. On the plus side, the yen is higher by 0.3%, seemingly on the back of position adjustments as given the other risk signals, I would not characterize today as a risk-off session.

In the EMG space, there are far more losers than gainers today, led by the Turkish lira (-1.0%) and the Russian ruble (-0.8%). The lira is under pressure after new economic projections point to a larger economic contraction this year of as much as 3.4%. This currency weakness is despite the central bank’s boosting of FX swaps in an effort to prevent a further decline. Meanwhile, despite oil’s ongoing rebound (WTI +3.6%) the ruble seems to be reacting to recent gains and feeling some technical selling pressure. Elsewhere in the space, we have seen losses on the order of 0.3%-0.5% across most APAC and CE4 currencies. The one exception to the rule is KRW, which rallied 0.6% overnight as expectations grow that South Korea is going to be able to reopen the bulk of its economy soon. One other positive there is that demand for USD loans (via Fed swap lines) has diminished so much the BOK is stopping the auctions for now. That is a clear indication that financial stress in the nation has fallen.

On the data front, this morning brings the ADP Employment number (exp -21.0M), which will be the latest hint regarding Friday’s payroll data. Clearly, a month of huge Initial Claims data will have taken its toll. Yesterday’s Fed speakers didn’t tell us very much new, but merely highlighted the fact that each member has their own view of how things may evolve and none of them are confident in those views. Uncertainty remains the word of the day.

For now, the narratives of the past several weeks don’t seem to have quite the strength that they did, and I would say that the focus is on the process of economies reopening. While that is very good news, the concern lies after they have reopened, and the carnage becomes clearer. Just how many jobs have been permanently erased because of the changes that are coming to our world in the wake of Covid-19? It is that feature, as well as the nature of economic activity afterwards, that will drive the long-term outcome, and as of now, no clear path is in sight. The opportunity for further market dislocations remains quite high, and hedgers need to maintain their programs, especially during these times.

Good luck and stay safe
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