The German constitutional court last week made a surprise decision on the bond purchase program by the European Central Bank (ECB). The ruling could potentially undermine the ECB’s independence – and threaten to fuel fragmentation within the euro area in the long run. This comes as the ECB’s actions to cushion the pandemic’s fallout already looked meek compared with the Federal Reserve’s. As a result, we are reviewing our overweight on euro area peripherals, or government bonds from southern-tier nations.
The German court gave the ECB three months to justify its 2-trillion-euro bond purchase program to the German parliament. Otherwise the Bundesbank – the ECB’s largest shareholder and bond buyer – would have to pull out of the program, the court said. The ruling put a spanner into the works of the ECB’s “whatever-it-takes” commitment – at a time when effective execution of policies is critical to safeguard the economy against damages from the coronavirus shock. As evidence of the vulnerability in the euro area’s hardest-hit economies, the yield spread between Italy’s government bonds and their German counterparts has been widening since late March despite the ECB’s stepped-up purchase program. In contrast, the spread between U.S. investment grade and U.S. Treasuries has narrowed from its peak in March – and has steadied since mid-April as the Fed’s pandemic response allayed credit concerns. See the chart above.
We have seen nothing short of a policy revolution in response to the coronavirus outbreak – in terms of speed, size and monetary-fiscal coordination. The successful execution of policies and programs is key – and the German court ruling may be a cautionary tale of how execution can be scuppered. Explaining itself to the German parliament shouldn’t be a problem for the ECB. Yet having to do so undermines its independence, a precondition for its “whatever-it-takes” stance. This is partly a consequence of the blurring of boundaries between monetary and fiscal policies – and particularly problematic in the euro area due to the lack of a joint fiscal authority. We had highlighted the crucial role of proper guard rails around policy coordination in Dealing with the next downturn.
The ruling is unlikely to have immediate consequences for the ECB’s monetary policy and has led the European Union’s top court to state that it alone had the power to rule on whether EU bodies were in breach of the bloc’s rules. Yet it could create longer-term issues for the central bank and the euro area. Why? It highlights legal uncertainty on the Bundesbank’s ability to support ECB policies. The German court drew red lines on two key parameters – the capital share of each member central bank of the ECB and a 33% cap on buying any country’s debt – potentially limiting the size of the ECB’s bond purchases. Undermining the ECB’s independence could pave the way to renewed euro area fragmentation, the risk currently topping BlackRock’s Geopolitical risk indicator. Market confidence in the ECB’s ability to contain crises could be dented. This will make it even harder to ensure sovereign debt sustainability in the coming years, especially in the periphery, in our view.
The bottom line
We are putting our view on euro area peripheral bonds on review despite relatively attractive valuations, as the German court case challenges the ECB’s independence. One offset to this risk: The ECB may up the scale of its bond purchases in coming months, which would support peripherals and euro area credit. Over the strategic horizon, we already see a diminished case for nominal developed market bonds due to the market reaction and policy response to the outbreak. Yields have fallen close to lower bounds, reducing return expectations and the ballast properties that traditionally help nominal government bonds cushion portfolios against risk-off episodes. The picture may look even gloomier over coming years if supply chain changes pick up pace, monetary policy is more accommodative and inflation risk rises. The court ruling offers a glimpse of challenges to effective policy execution – and adds to reasons to be wary of nominal government bonds.
Elga Bartsch, PhD, is Head of Macro Research for the BlackRock Investment Institute. She is a regular contributor to The Blog.