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Will September 12th lead to a resounding 'nein' for the ESM?

Germany’s Constitutional Court is set to rule on the legality of the European Stability Mechanism (ESM) in September. But Morgan Stanley cautions of rising political risks leading up the German vote.

The European Financial Stability Facility (EFSF), Europe’s original bailout fund, is fast running out of cash after attempting to bail out Greece and the like. And the EFSF is going to struggle if it needs to help the likes of Spain and Italy as well. Cue the European Stability Mechanism (ESM) to save the day. That’s all just great.

But it looks like Morgan Stanley is out to ruin your weekend. For the ESM to come into play, the German Constitutional Court needs to ratify the proposal. But Morgan Stanley says that there is still a hefty chance that ESM is a no-go:

"In our view, there is a non-negligible risk that the German Constitutional Court will voice concerns about the ESM and, potentially, also the fiscal compact on September 12. Given that the EFSF is still in operation, given that the Court views the scope of the German constitution as being exploited already, and given its record of voicing concerns about European integration, we see a 40% chance that the Court bans Germany from ratifying the ESM treaty, at least for now. But, our base case is that the Court denies requests for emergency injunctions, allowing Germany to ratify both European treaties." 

And what if it is a resounding ‘nein’?

"We believe that markets are not priced appropriately for the downside tail risk of a possible 'no' verdict. Morgan Stanley strategy teams explore the implications for equity, credit, rates and FX markets of the various possible outcomes. Best ways to position for a downside surprise include October payer spreads on iTraxx Main, bullish December Bund swap spread wideners, a string of 1/2/3 mth EURUSD puts, and in equities long insurance (SXIP) versus short banks (SX7P) as a sector pair trade." 

And there’s more to be uncertain about:

"In our view, investors need to recognise the pivotal role of the Court in German politics and in European integration. The standard legal procedure, which first looks at whether to grant an injunction and only later looks at the case itself, is key, because the two decisions are taken according to different legal criteria. In the current case, the Court seems to be diverting from the standard procedure by holding a public hearing in July and by providing a summary assessment on September 12, thereby adding further to the uncertainty."  

Enjoy the weekend!

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