In addition to the growing evidence of serious economic slowdown in the EZ one of the key factors that has been weighing on euro, driving the currency to fresh yearly lows, has been the uncertainty around the implementation of ESM. ESM – the European Stability Mechanism – is the permanent replacement for the EFSF – the original European bailout fund cobbled together as response to EZ periphery debt crisis that started in 2010.

The ESM was supposed to have become operational in July, taking over the disbursement of funds from EFSF and having the flexibility to lend money directly to the banks thus avoiding further sovereign liability and protecting access of such members as Spain and Italy to the capital markets. However, the rollout of the ESM has been delayed by constitutional challenges in Germany where the court has agreed to consider a variety of challenges.

The group “Europe Needs More Democracy” filed a complaint at the Karlsruhe-based Federal Constitutional Court on behalf of about 12,000 people who signed up via the Internet. Peter Gauweiler, a lawmaker from the Bavarian sister party of Chancellor Angela Merkel’s Christian Democrats, also filed a petition with the court as well as opposition Left Party lawmakers.

All of the plaintiffs claim that the ESM and the fiscal pact undermine the principle of democratic rule and intrude on the powers of German lawmakers. The new instruments overstep the limits the German constitution sets for European integration and should only take effect if approved by a referendum, they contend.

At the heart of the matter is the fact that the ESM was established as a two line amendment to the EU treaty that would avoid any referendums, and would grant the EU vast fiscal powers to disburse funds from one member nation to another without the direct consent of the citizens. It was in fact the first attempt by EU officials to create a permanent supra-national institution to address the sovereign debt crisis in the region that enjoys a single currency, but vastly different fiscal and balance sheet positions.

Most experts expect the German court to uphold the ESM provision, but the fact that the judges have decided to postpone their decision until September has irked EZ officials who fear that the uncertainty will create further turbulence in the capital markets. Eurogroup chairman Jean-Claude Juncker told Der Spiegel over the week-end that he does not expect that the German Constitutional Court will block the ESM. Juncker noted that constitutional questions had also been raised in other Eurozone countries: “In Estonia the rescue fund was examined by the highest court and was confirmed. Therefore, I do not expect the judges in Karlsruhe to block it.” However, he noted that it was “not helpful” that the German Constitutional Court has signaled that it might take until autumn before it will deliver a first ruling.

Although chances are minimal that the opponents of the ESM will succeed in their constitutional challenge of the amendment, the risk and uncertainty remain. Should the German court shock the markets and uphold the challenge, the ruling could send EUR/USD tumbling below the 1.2000 level. In the meantime, any rally will likely be capped as investors await the resolution of this issue.