Markets

Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

Incoming, Mr Draghi.

The decision by European Central Bank policy makers in December to change the rules of their Public Sector Purchasing Program has had a pretty consequential outcome.

By letting national central banks -- Germany in particular -- buy their government bonds at yields below the current deposit rate of minus 40 basis points, ECB officials have unwittingly spelled the end for the quantitative easing program as we know it.

After months of buying, national central banks are simply running out of longer-dated securities they can purchase as they bump up against ECB rules that stop them taking on more than a third of any particular issue. They will therefore have to buy more shorter-dated debt at heavily negative yields.

Sinking Feeling
Yields on German two-year government bonds are approaching an all-time low
Source: Bloomberg

At present, the only German government bonds to yield more than minus 40 basis points are those of four years' duration or more. By April, the Bundesbank will own a third of every bund of more than five year's duration, according to Credit Agricole.

The Bundesbank will be forced into buying bonds yielding less than the deposit rate whether it wants to or not -- and it's more likely not, given that they'll be buying something that gives them back less than they paid.

German Premium
The cost of owning two-year German debt is soaring compared to the European overnight rate
Source: Bloomberg

The ECB has said such purchases “are permitted to the extent necessary” and that “priority will be given to purchases of assets with yields above the deposit rate.” Unfortunately it is too late for such semantics -- Germany is up to the QE brim.

The Bundesbank's longstanding demands to end the program will reach a crescendo, especially when, not if, inflation breaches 2 percent. German officials got reinforcement on Friday, when Bank of Austria Governor Ewald Nowotny said policy makers would discuss reducing QE in the middle of the year.

Up and Away
Expectations that inflation will rise have climbed steeply since mid-2016
Source: Bloomberg

A further worry is that the weighted average maturity of the Bundesbank's holdings has been falling. According to Royal Bank of Scotland, the WAM of the central bank's holdings fell to 9.4 years in January from 12.1 years in December and 10.3 years in November. The next data, due March 6, are likely to show a further decline in this gauge.

The knock-on effect will be systemic. As Gadfly has noted before, the plumbing of the Eurosystem revolves around the highest quality repo collateral -- usually short dated German government debt.

The scarcer that gets, the higher the risk the system jams up. The Bundesbank holds less than 10 percent of one- to seven-year maturities at present, but will have to ramp this up to 33 percent within a year, just to fulfill requirements that say the allocation of purchases should be roughly proportional to the size of each economy. 

Spot the Crisis
The RepoFunds Rate Germany barely budged during the whole sovereign debt crisis
Source: ICAP Information Services

Two-year German bonds are now yielding close to their lows of minus 0.8 percent. The 10-year benchmark is special on repo at minus 1 percent, with the cheapest to deliver into the bund futures contract at minus 1.25 percent. And this is nowhere near the quarter-end, when the next big squeeze is due.

The ECB is going to have to do more to free up the repo market. There's little hope they'll remove or amend the QE program's 33 percent limit. 

Mario Draghi will be under a lot of pressure at the March 9 policy decision to address the problem. As things stand now, something will have to give.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Marcus Ashworth in London at mashworth4@bloomberg.net

To contact the editor responsible for this story:
Jennifer Ryan at jryan13@bloomberg.net