Global Daily – Could the German court restrain the ECB?

by: Nick Kounis , Joost Beaumont , Jolien van den Ende , Bill Diviney

ECB View: Most likely that German court will follow ECJ judgment, but what if… – The German constitutional court will announce its decision tomorrow on whether the ECB’s public sector purchase programme is legal. The court previously made a judgement on this question on 15 August 2017 when it decided to refer several questions to the Court of Justice of the European Union for a preliminary ruling (see here). On 11 December 2018, the European Court of Justice concluded that ‘the ECB’s PSPP programme for the purchase of government bonds on secondary markets does not infringe EU law’ (see here). However, in the reasoning why it made this judgement, it set out a number of factors that could be seen as a framework for judging the legality of future asset purchases. Following the ECJ judgement, the German constitutional court will make a final decision.

When the German constitutional court referred the decision to the European court in 2017, it expressed its doubts about the PSPP. It noted that ‘significant reasons indicate that the ECB decisions governing the asset purchase programme violate the prohibition of monetary financing and exceed the monetary policy mandate of the European Central Bank’. However, the court does not readily overturn rulings of the ECJ. Lat year, the German court President Andreas Vosskuhle noted that under the German constitution, the court can only disregard an EU ruling if it’s ‘arbitrary and gravely unreasonable’.  This looks like a high bar.

The German ruling relates to the PSPP, but one caveat is that the recently announced PEPP goes much further, and could come under the spotlight at some stage. For instance, the ECJ noted that the focus of the PSPP was to raise inflation and highlighted that it did not create incentives for member states to run unsound budgetary policies. This reflected that there were issue(r) limits, purchases were made under the capital key and that there were strict eligibility criteria. The PEPP is not constrained by limits, will deviate more significantly from the capital key, while Greek government bonds have been included despite their sub-investment grade rating. Meanwhile, the PEPP seems focused on preventing fragmentation (ECB speak for capping country spreads) at least as much as targeting inflation.

If the German court does rule that the PSPP is illegal, it would have major negative ramifications for eurozone government bond markets in particular, and financial markets more generally. The court does not have jurisdiction over the ECB, but it could prevent or restrain the Bundesbank’s purchases of German government bonds. Theoretically, the ECB could purchase these instead, though that is complicated as there is no risk sharing when it comes to government bond purchases. In addition, a negative ruling would damage the credibility of the ECB  more generally. It would undermine its commitment to do ‘whatever it takes’ and would likely cast a shadow on the PEPP. Specifically its commitment to ‘to increase the size of the PEPP and adjust its composition, by as much as necessary and for as long as needed’. (Nick Kounis)

Euro Rates: ECB purchased net EUR 142bn of assets in April, focus on fighting fragmentation – Eurosystem net asset purchases totalled EUR 142bn in April, which was more than double the EUR 67bn that it had purchased in March. The sharp increase reflects that the EUR 750bn PEPP started towards the end of March, with its purchases in full swing in April. So far, the Eurosystem has already spent EUR 119bn (16%) under the PEPP, implying that at the current pace, it will have completed the programme by early November. Meanwhile, the central bank purchased EUR 38.5bn under the APP, including EUR 18.5bn under the extra envelope of EUR 120bn. In March, already EUR 31bn was spent of the extra envelope, taking total purchases of the envelope to almost EUR 50bn. At the current pace, the EUR 120bn will be spend before the end of August.

Unfortunately, the ECB did not publish any further details on the breakdown of the PEPP, which it will start doing on a bi-monthly basis. However, the split of the APP showed that the central bank’s focus was on the government bond and SSA market, as the share of the PSPP in the total APP was 77% in April. This was up from 73% in March and compares to an average of 60% at the start of the year. The share of the CSPP was 14% and that of the CBPP3 9%. The step up in PSPP purchases likely reflects the central bank’s fight against the fragmentation in the government bonds markets.

Indeed, the Eurosystem has been overweighting Italian government bonds within the PSPP. Purchases by jurisdiction show that the Eurosystem net purchases of Italian government bonds were double what is implied by the capital key, while purchases of French government bonds were also of a larger size than implied by the capital key (see table below). Moreover, to compensate for the additional purchases of BTPs and OATs, the Eurosystem bought less German and Dutch government bonds. Net asset purchases of DSLs have even been slightly negative since the beginning of this year. These trends clearly show that the ECB is fighting hard to cap the Italian spread (indeed most of the deviation was in March and April). Its behaviour in terms of purchases, policy announcements and other verbal interventions suggest that the ECB is aiming to keep the Italian spread at or below 250bp. Consequently, we judge that the central bank is engaged in yield spread control. One caveat is that the above analysis is based on the details of the APP, and we do not yet have a breakdown of the PEPP. (Joost Beaumont and Jolien van den Ende)

US Macro: Bottoming, but not yet recovering – Last week saw confirmation that the contraction in GDP already started in Q1, and initial jobless claims are continuing in their millions. However, with a number of states now beginning to reopen their economies (states representing around 20% of GDP, including  Texas, Florida, and Georgia), we see some signs under the surface of a bottoming in economic activity. Weekly indicators such as electricity output have stabilised, while fuel end sales, rail freight, and daily air passenger numbers have increased slightly. These recoveries all come from a low base, and are hardly spectacular. But the data at least suggests a stabilisation in activity at low levels. Meanwhile, jobless claims continue to rise at a dramatic, if decelerating pace. Initial jobless claims for the week to 24 April came in at 3.8mn, down from 4.4mn the week earlier. Total confirmed recipients of benefits stood at c18mn as of 17 April, however, which is much lower than the 27mn initial claims since mid-March. At the same time, some states are now reporting falls in continuing claims, particularly those who implemented lockdowns earlier – most notably, California saw a dramatic drop in continuing claims, with 1.9mn now receiving benefits, down 500k from the 2.4mn the week prior.

Overall, the bottoming in indicators led has kept the New York Fed’s Weekly Economic Index broadly stable at -11.6% for the week to 25 April (data for the week to 18 April was revised up to -10.9%, from -11.7%). Should this level of activity persist throughout the rest of Q2, it would be consistent with GDP growth of -42% qoq annualised – a 10pp bigger contraction than our base case of -32% – although we expect activity to pick up from these low levels in the coming weeks, as states slowly re-open their economies. With that said, the reopening is being deliberately phased in three week increments, to enable careful monitoring of the impact on the spread of covid-19, and this phased approach means the recovery in the economy will also be more gradual than the initial sudden stop. At the same time, the risk of restrictions having to be re-imposed is significant, which would further dent the recovery pace. (Bill Diviney)