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Why Tomorrow It Could Get Even Worse

While today's market dump was certainly dramatic, it was a function of the scant liquidity in the market (as we warned would be the case first thing) and outsized moves following last week's mauling, not the result of any fundamental (or not so fundamental) news.

That could change tomorrow, and change for the worse, because as Barclays reminds us, tomorrow is when the European Court of Justice (ECJ) is scheduled to hear testimony on the ECB’s non-existent Outright Monetary Transactions program (OMT). Recall that the OMT is the imaginary (again: non-existent) byproduct of Draghi's "whatever it takes" speech: a byproduct that was supposed to exist purely in the imaginary realm (as it was merely a verbal bluff, one which was never meant to be actually activated), and never actually take practical shape (hence, why the OMT's legal term sheet still does not exist, over two years later).

Sadly for Draghi, and the entire Deus Ex theater that managed to send European peripheral bonds from record wides yields to record low, tomorrow it will attain some much dreaded shape.

And while a ruling on the legal questions forwarded by Germany’s Constitutional Court is not expected this year, the hearing and questions posed by EU judges may give some early insights into their views and to what extent they might share the view of the German court that, unless several restrictions are imposed, the OMT should be considered illegal under European law.

As Barclays notes, specifically the EU court may agree that the ECB cannot promise pari passu treatment with other creditors in the case of nominal losses (haircuts) on its public bond holdings but must insist on full repayment.

What's worse is that in addition to undercutting and mooting all of Draghi's July 2013 bluster, next to the OMT itself, the ruling could also have an adverse impact on the effectiveness and design of broad-based ECB government bond purchases (QE) which many banks believe will be announced by Q1 15. Unless they aren't of course, should the ECJ shoot itself in the foot and demand more clarity on the OMT which can only have an adverse outcome.

Full comment from Barclays:

European Court of Justice scheduled to hear testimony on the ECB’s OMT on 14 October

 

The ECJ has scheduled a hearing on the ECB’s OMT for next Tuesday, 14 October (starting at 9am CET), which we expect to last all day. Under the OMT, the ECB could purchase, without limitation, bonds of a member state that has entered into an ESM aid programme and agreed to be subject to its conditions. Earlier this year (see German Constitutional Court's referral of key legal OMT aspects to European Court of Justice is good news, 7 February) the German Constitutional Court (GCC) in an unprecedented move referred a long list of questions to the ECJ (see Appendix below) for a preliminary ruling after it declared admissible a constitutional complaint by some 30,000 plaintiffs (Gauweiler and others) against the OMT. The discussion and specifically questions posed by the EU judges to the parties involved (the ECB, etc) during the hearing might give some early insight on their views. We do not expect the ECJ to come to a ruling this year but the court’s advocate general may announce the schedule for the proceedings next week. Usually, it takes the ECJ about 16 months on average to rule on cases referred by national courts which implies that the OMT ruling could come by June.

 

German court insists on several restrictions for the OMT

 

The German constitutional court put some pressure on the EU court and made clear its view last February that there are important reasons to assume that the OMT would be illegal under EU law as it exceeds the European Central Bank’s monetary policy mandate and violates the prohibition of monetary financing of the budget, unless certain restrictions are imposed. These should require “that the acceptance of a debt cut must be excluded, that government bonds of selected Member States are not purchased up to unlimited amounts, and that interferences with price formation on the market are to be avoided where possible.”

Clearly the latter would make an ECB option to proceed with full blown public QE virtually impossible.

So for all those who, rightly, point to the market's oversold condition, news out of Europe tomorrow could lead to even more selling especially where it really hurts: Europe's peripheral, and massively mispriced, bonds. A fair warning, just in case anyone is feeling particularly  BTFDippy.