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A blast of cold air has blown through European bond markets and it's tempting to imagine that events in a court room in Germany caused the sudden chill. The Constitutional Court in Karlsruhe is hearing arguments this week on the legality of the European Central Bank's Outright Monetary Transactions programme, the pledge to buy as much euro zone debt as it takes to stabilise the market. The outcome of the hearing won't be known until September and the German court's decision isn't even binding on the ECB, but there are other reasons to believe that the euro zone crisis is far from over, whatever the French President, François Hollande, would have you believe.
Everything that looked more risky than cash came under pressure this morning in a bout of fretting by investors that governments would stop pumping money into the markets. Shares in London, Paris and Frankfurt swooned and, noticeably, there were sharp falls in the euro zone periphery bond markets with Greek government debt climbing above 10 per cent and Spanish, Portuguese and Italian yields following suit. There are two trends at work here: the first is a generalised feeling that the great monetary policy experiment by governments everywhere may be coming to an end, a sense that it is finally time for an end to easy money and negative real interest rates. But in Europe, there is also unease that the political and emotional commitment to the euro zone may again be tested. The venue for that test may be Karlsruhe.
Just to recap: the pledge made last September by Mario Draghi, ECB president to do whatever is necessary to prevent the bankruptcy of a euro zone member state was enough to put an end to the market attacks on euro zone periphery bonds. No bond purchases were necessary under the OMT programme and President Hollande recently boasted that the euro zone crisis was over. Unfortunately, the central bank whose financial clout ultimately underpins the power of the ECB was never happy with the idea of unlimited bond purchases. Jens Weidmann, president of Germany's Bundesbank and a member of the ECB governing body, opposed OMT on the grounds that the ECB was entering dangerous inflationary territory but he failed to overrule the political consensus for action.
The Bundesbank chief's doubts are widely held in Germany where there is huge anxiety that German taxpayers will ultimately be forced to underwrite the purchase of Greek or Spanish debt as their banks crumble into dust. The Court will not rule on the legality of the ECB's decision but on whether the German government was right not to oppose it. If the judges in Karlruhe decide that OMT is illegal, it will give huge succour to political opponents of Chancellor Merkel, including Alternative für Deutschland, Germany's anti-euro party. More importantly, it will cast doubt on the solidity of political support for the euro, which ultimately depends on the pockets of German taxpayers.
Politics and court cases aside, there are worrying signs that the ECB pledge to support euro zone bonds was more of a band-aid than a cure. According to the Financial Times, euro zone banks have been reducing their cross-border holdings of euro zone government debt. During the years up to the financial crash, European banks built up large holdings of non-domestic government bonds, a major factor in shrinking the yield gap between German bunds and the bonds of weaker economies, such as Greece and Portugal. The widening of the banks' government debt portfolios was seen as evidence of euro zone financial integration but the reverse is now happening. Cross-border bond holdings are now lower than when the euro was launched 14 years ago, suggesting that the euro zone bond market is becoming more nationalistic and less European.
The bond market jitters may just be a reality check or it may be the beginning of a global bond correction to higher yields. If it is the latter, we are in for trouble. It's one big headache for those judges in Karlsruhe.
Carl Mortished is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights.
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Carl Mortished