After committing to do whatever it takes to defend the euro a month ago, the ECB has delivered broad details about how this will work with the key elements of its plan (called Outright Monetary Transactions or OMT) being:

• unlimited secondary market bond purchases by the ECB out to 3 year maturities
• the ECB will not rank senior to other investors; no formal announced yield target, but the ECB clearly has objectives in mind
• bond buying conditional on a country applying for assistance to the Euro-zone bailout funds and agreeing and abiding by its requirements; and any bond buying to be sterilised, ie, it won’t be quantitative easing.

This has to be seen as very positive. Europe now has a well articulated and credible program to bring bond yields in troubled countries back to sustainable levels. The combination of the ECB acting in concert with the bailout funds effectively leverages up the firepower of the latter overcoming concerns that they don’t have enough resources.

Buying shorter term bonds should transmit the impact out to longer term yields as well – reflecting this Spain’s ten year bond yield has fallen below 6% for the first time since May. While it would have been nice to see the ECB announce quantitative easing by not sterilising its bond buying, the current program is focused on bringing borrowing costs back into line across Europe and making sure that current very easy monetary conditions apply for all of Europe and not just a few countries – QE is still likely at some point to deal with the ongoing recession. All that is now required is for countries like Spain to apply for assistance and agree to the terms, which it is likely to do soon ahead of a bond auction in October. In fact Spain has little choice but to apply because if it doesn’t its bond yields will rebound.

The bottom line is that the ECB is delivering on its commitment to defend the euro. The tail risk of a euro breakup triggering a rerun of a deep GFC style recession in Europe and potentially a global recession is receding. The ECB under Mario Draghi is very different to that under Trichet. Starting with last year’s bank funding operations and now with its bond buying program Draghi is proving to be a pragmatic man of action.

In Australia there were no surprises from the Reserve Bank which left interest rates on hold at 3.5% with the RBA continuing to see growth running around trend. However, the RBA does seem to be getting a bit more concerned about the slowdown in China and sharp falls in commodity prices.

Our assessment is that with the mining boom losing momentum led by sharp falls in iron ore prices and recent monthly indicators such as retail sales, building approvals and employment growth softening anew its likely that growth will slide below trend highlighting the need for lower interest rates.

Standard variable mortgage rates at 6.8% are still well above the 6% or so levels that were required to generate a decent recovery through the last two easing cycles into 2002 and 2009. Reflecting these considerations we expect the RBA to cut the official cash rate to 2.75% in the next six months, starting with a 0.25% cut in either October or November.

Major global economic releases and implications

• US economic data shows that growth is continuing but remains sub-par and not enough to satisfy the Fed.
  While the new Markit manufacturing conditions PMI rose marginally in August, the ISM manufacturing conditions index deteriorated slightly leaving it below 50 for the third month in a row and jobs growth of just 96,000 in August is way below the 200,000 a month need to sustainably reduce unemployment. Construction spending also fell in July and mortgage applications fell over the last week. On the positive side though the ISM nonmanufacturing conditions index rose in August and productivity growth was revised up for the June quarter.
• Final August business conditions PMIs for the Euro-zone confirmed a slight improvement in manufacturing but a slight deterioration in the services sector leaving the overall composite indicator little changed from where it’s been over the past few months, which is consistent with a mild recession in Europe.
• While China’s manufacturing PMIs fell in August, non-manufacturing conditions improved. Chinese authorities announced approvals for infrastructure spending focused on road and rail projects. While it’s not sure whether this is real stimulus or not given uncertainty over the financing or just the approval of five year plan projects that would happen anyway, it triggered a strong bounce in Chinese shares. After a 3 year 40% slump in share prices, the Chinese share market is primed for a rebound with a record low historic PE of 11 times.

Australian economic releases and implications

• Australian economic data was mostly soft. The good news was that GDP growth over the year to the June quarter was 3.7% which is well above that in most other comparable countries. However, growth in the quarter slowed to just 0.6% and going forward is likely to remain subdued as the Government handout driven boost to consumer spending looks to have run its course, non-mining sectors of the economy are still struggling and the mining boom seems to be rapidly losing momentum led by sharp falls in iron ore prices.
• Weakness was indicated in a range of indicators: with retail sales falling sharply in July; employment falling in August; job ads continuing to slide pointing to more labour market weakness ahead; the trade deficit widening in July; soft readings for manufacturing, services and construction sector conditions indicators; and company profits falling for the third quarter in a row. On balance we see growth running around 2.5% over the year ahead, which is not disastrous but still well below trend and consistent with further RBA interest rate cuts.

Major market moves

• Share markets rose as the ECB delivered details on its bond buying plan resulting in a further pricing out of the risk that the Euro-zone will blow apart triggering a global recession. Chinese and Asian shares also benefitted from infrastructure project approvals in China.
• Commodities prices also rose although the iron ore price made new lows. Renewed talk of interest rate cuts and worries about the iron ore price also saw the $A fall below $US1.02 mid week before recovering its losses.
• Bond yields rose in major countries as safe haven buying reversed, but fell sharply in Spain and Italy.

What to watch over the week ahead?

• In the US the key focus will be on the Fed’s monetary policy meeting (Thursday) where we expect the Fed to unveil more monetary easing. Given support at the last meeting for further easing unless the economy strengthened soon and Bernanke’s Jackson Hole speech which made a strong case for quantitative easing by arguing that it has worked in the past, that its costs are manageable and that unless growth improves quickly unemployment will remain too high, we expect the Fed to extend its commitment to keep rates low into 2015 and to announce more quantitative easing involving the purchase of both government bonds and mortgage backed securities. But unlike in the past where QE1 and QE2 were specified in terms of the amount and time frame, QE3 is expected to be open ended with the Fed continuing it until the economy is judged to be on a sounder footing. While the absence of a dollar value might confuse some, the lack of an end point problem and the commitment to continue until growth is stronger will be a big positive to such an approach.
• In terms of US data, it’s a quite week until Friday when we expect higher food prices drive a pick up in inflation, but core inflation to remain benign, a solid 0.5% gain in retail sales and modest growth in industrial production.
• In Europe, the German constitutional court’s ruling on the validity of the ESM bailout fund will be delivered on Wednesday and is likely to clear the fund but impose some conditions around it. Dutch elections will also be watched as another test of Euro-zone solidarity but recent polls suggest a radical antiausterity or anti-bailout result is unlikely. A Eurogroup/European finance ministers meeting on Friday may also see Spain apply for bailout fund assistance as is required under the ECB’s bond buying plan.
• Chinese August data for exports and imports (Monday) and bank lending (Tuesday) will also be released.
• In Australia, expect a modest gain in housing finance (Monday), but continued sub-par reading for business conditions and confidence in the NAB business survey (Tuesday) and for consumer confidence (Wednesday).
• In terms of consumer confidence talk of rate cuts is likely to have been offset by bleak news regarding ironore rices and a run of soft economic news. Data for June quarter dwelling starts will also be released.

Outlook for markets

• Event risk remains high for investors over the next few weeks with the Fed meeting, Spain yet to apply for
  assistance, the German constitutional court ruling, Dutch elections, and the European Union decision on Greece that may create volatility in the month ahead along with ongoing uncertainty about Chinese growth. However, with the ECB undertaking a major game changer, the Fed providing a win/win for the US share market in that either the economy improves or the Fed eases, further easing likely in China and shares cheap, we still see shares being higher by year end. It’s also a good sign that US shares have broken up to a new post GFC high. So any weakness over the next month or so will likely provide a good buying opportunity.
• While sovereign bonds in safe countries are a good diversifier, bond yields in major countries remain very low and point to low medium term bond returns. Corporate debt is a better proposition for those after income but not willing to accept the volatility that comes with shares.
• In the short term the $A is vulnerable should iron ore prices continue to fall, however, overall it should remain strong as global central banks undertake further monetary easing, commodity prices bounce back into next year and as central bank reserve diversification continues.

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