By Dhara Ranasinghe and Olga Cotaga

LONDON (Reuters) – Southern government bonds lost ground on Tuesday, pushing yields higher, after Germany’s top court ruled that the Bundesbank must stop buying bonds under the European Central Bank’s stimulus scheme if the ECB cannot justify the purchases.

The ruling that Germany’s central bank must end the government bond purchases within three months unless the ECB can prove they are needed clouds the bloc’s monetary policy outlook at a time when the coronavirus is hammering economic growth.

The decision did not apply to the ECB’s PEPP coronavirus pandemic-fighting programme, a 750 billion-euro ($812 billion) scheme introduced in March at the height of a coronavirus-induced financial market rout.

But the ruling raised concern about further expansions in ECB asset purchases. That manifested in a sharp selloff in Italian government bonds, pushing yields nearly 20 basis points to a week-and-a-half high of 1.947% and leading the gap over safe-haven German Bund yields to 251 bps, the widest in around a week and a half.

“The good news is that the ruling does not seem to apply to the PEPP, but there is a bigger concern that it limits the ability of the ECB to `do whatever it takes’,” said Sarah Hewin, chief Europe economist at Standard Chartered.

Since then, Italian yields have subsided, after German Finance Minister Olaf Scholz said the ruling by Germany’s top court on the ECB’s bond-buying programme allows the bank to make such purchases in principle and the Bundesbank can continue to take part for now.

Italian 10-year yields were last up 15 bps at 1.903%.

“I would expect that from the SPD (Social Democratic Party of Germany, of which Scholz is a member), but it’s now whether the Conservatives would share that view as well … then I would expect more of a market impact,” said Peter Chatwell, head of rates strategy at Mizuho.

Chatwell added that even though PEPP was not the topic of this particular decision, “I think we can infer from this decision that if there was to be a decision about the pandemic programme, then it would be unlikely to be supported.”

Amassing nearly 3 trillion euros of bonds since 2015, the ECB has long relied on asset purchases to support the euro zone economy through crises and the threat of deflation.

The court’s ruling hit other European assets as well, sending the euro down to a six-day low of $1.0826, setting it for its biggest daily drop in more than a month. The common currency was last down 0.3% at $1.0864.

Among stocks, the pan-European index cut some of its gains following the ruling and was up 1.8%. German shares briefly touched lows for the day. Euro zone banks halved their gains and were up 1.4%.

Other southern European countries’ debt also took a hit, with Spain’s 10-year bond yield gap over Germany widening to 145 bps, up around 8 bps from late Monday levels. Spanish 10-year government bond yields were last up 2 bps at 0.851%

As the selling pressure in peripheral bonds gathered pace, investors moved back into German bonds, allowing that market to recover from a sell-off after the court ruling. The 10-year Bund yield was last down 1.1 bps at -0.57%.

“The court ruling highlights that core countries not only face political hurdles to any form of liability sharing but also legal hurdles,” said Richard McGuire, head of rates strategy at Rabobank.

ECB policymakers will discuss the ruling at a Governing Council meeting starting at 1600 GMT, a spokesman for the bank said.

($1 = 0.9234 euros)

(Additional reporting by Saikat Chatterjee, Joice Alves, Sujata Rao and Thyagaraju Adinarayan; writing by Dhara Ranasinghe; editing by Alexander Smith, John Stonestreet, Larry King)