Currency traders must have been on edge as the head of Germany's Constitutional Court began a hearing on Wednesday morning on whether the country could ratify the permanent European bailout fund.
As Andreas Vosskuhle droned on in legalese, the eurobriefly tumbled to a session low. Then came the ruling that most market participants had already priced in — a conditional approval.
The euro rose to a four-month high against the dollar and broke above option barriers at $1.2900, according to traders, cited by Reuters.
"There are a lot of things to happen over the next couple of months and this is one of the things that could have derailed us at a very early stage," Rob Carnell, chief international economist at ING, told CNBC after the decision.
"So, I think entirely appropriate that markets should respond with a small sigh of relief, but nothing more than that," he added.
The ESM was due to take effect in July as a backstop to protect the debt crisis from spreading by providing loans to troubled euro zone members. It is designed to replace the European Financial Stability Facility, which has backed bailouts for Greece, Portugal and Ireland.
Germany, which contributes more than 25 percent to the 500 billion euro ESM needs to ratify the bailout fund for it to succeed.
But the German court also attached conditions to Germany's participation. The government has to get approval of the lower house of parliament, for example, if Germany's exposure to the ESM exceeds 190 billion euros. The government also has to keep both houses of parliament informed about the bailout fund.
A negative ruling would have jeapordized the future of the ESM and thrown a curve ball at the single currency.
It would have also backfired on the ECB's plans to intervene in the debt markets to lower debt costs, John Noonan, Senior FX Analyst at Thomson Reuters, told CNBC Asia’s “Squawk Box”before the ruling was announced.
The euro has risen almost 7 percent since late July when the European Central Bank’s (ECB) President Mario Draghi calmed panic-stricken markets by pledging to save the euro area from collapse. Draghi followed that by outlining plans last week to
Both Italy and Spain have been pressured by high borrowing costs this year and when yields on Spanish bonds surged above 7 percent in July, the euro fell to two-year lows against the dollar as panic gripped financial markets. That was when Draghi stepped in with tough talk.
Currency analysts said a positive outcome from the German Court ruling was already priced into the markets, so Wednesday's decision is unlikely to lead to a major rally, rather it removes a dark cloud.
Caveats to the court’s ruling on the bailout fund are unlikely to derail the process that appears to be in place to end the debt crisis, currency analysts said earlier in the day.
“There has been a rapid rebound in the euro from $1.21 all the way up to $1.28. Clearly the market is taking Draghi seriously and it is also expecting quantitative easing from the Fed, so there is more room to rally,” Olivier Desbarres, Head of FX Strategy at Barclays told CNBC.
—By CNBC’s Dhara Ranasinghe and Deepanshu Bagchee