ECB: Pending shortage of assets that qualify for purchase under QE program - BBH

Research Team at BBH, suggests that the issue that has emerged and will continue to be debated ahead of the ECB meeting on July 21 is about the pending shortage of assets that qualify for purchase under its QE program.  

Key Quotes

“Presently the purchasing is being done according to the "capital key", which is a function of GDP and population.

This means that it buys more German bunds than bonds from any other country.  At the same time, German is running a balanced budget and paying down debt.  Also, given fears that Brexit could trigger a sequence of events lead to the fracturing of the monetary union, Germany bunds have an embedded call option (for the new German mark).  

The ECB adopted two rules that increase the apparent shortage of Germany bunds.  No security can be included in the purchase program whose yield is lower than the discount rate (-0.40%).  There is also a cap on any issuer of 33%.  Almost two-thirds of German bunds have yields below the deposit rate.

Recall too that the purchases were initially were to end in September, but have been extended to next March.  We suspect that later this year, the ECB may extend it another six months.  To sustain the buying, the ECB can move away from the capital key, remove the deposit floor, or lift the issuer limit.  Many reports have focused on shifting from the capital key to the size of the debt market.  Under such a rule, Italy with its large stock of debt would be the single biggest beneficiary, while the amount of bunds that would be purchased would be almost halved.  

However, the capital key may be an important principle in decision-making as a compromise between large and small countries.  It seems that it may have too much gravitas to overrule as the first attempt.  We suspect the story itself may not be what it seems.  Tactically, such leaks often are aimed to hurt precisely that view or interest it appears to represent.  It may be more helpful to think about those kind of leaks being plants rather than dogged reporting or careless officials.”