Draghi unveils OMT; markets rejoice

Mario Draghi has coined a new financial acronym: OMT. It stands for Outright Monetary Transactions, and it’s the name of the ECB plan he unveiled last week.

Essentially, the plan is to buy an unlimited amount of short-term bonds of the crisis infected economies in an effort to drive down their borrowing costs.

Read: How the ECB will ease the crisis

What’s the catch? Draghi is now demanding these governments sign up for austerity and abide by strict fiscal and monitoring conditions. Otherwise, the bond-buying will cease.

The ECB will not target specific yield levels, but with Spain’s 10-year bond yield moving below 6% for the first time in four months, investors seem to agree the Draghi plan may work.

The hurdles for this bond buying are going to be fairly high. Countries must first agree to a bailout, Europe’s permanent rescue fund must be activated and shown to work, and leaders must find ways to ultimately deliver economic growth.

Read: Why to buy dividend stocks now

Some may argue all the ECB did was buy politicians more time, but stock markets closed at multi-year highs, with the S&P 500 reaching its highest level since before the collapse of Lehman Brothers. European stocks posted the largest weekly advance in three months.

And last week, Chinese stocks had their biggest gain in eight months. China approved infrastructure plans to build new roads and subways in 18 different cities. There’s speculation more cuts to the reserve requirement ratio may come this weekend and additional economic stimulus measures in the weeks ahead.

The euro hit a two-month peak against the U.S. dollar in choppy trading and the Canadian dollar touched a one-year high (US$1.0240). Canadian employers added more jobs (+34,000) than forecast in August while U.S. payrolls (+103,000) were weaker than expected.

Speculation rose that the Bank of Canada would be raising its target interest rate in the near future.

WTI Crude oil futures gained last week, but slipped back below the 200-day moving average on rumours the White House was contemplating a release from the Strategic Petroleum Reserve. Gold touched 6-month highs as the weak U.S. payrolls in August pretty much seals a QE3 announcement at next week’s FOMC meeting.

August was a good month

Stocks had the calmest month of August since 1995 as investors weighed weakening economic data against the increasing likelihood of additional central bank monetary policy easing.

Intraday price swings in the S&P 500 Index averaged 0.80 percent last month, the smallest fluctuation for any August in 17 years (The TSX had its fourth-calmest August). Volumes were also extremely low, with less than 5 billion S&P500 shares traded on 14 out of 23 sessions.

Read: When markets give you volatility, invest

The VIX dropped 7.7% to 17.5 in August. That’s 15% below its two-decade average of 20.7. Activity is likely to pick up in the catalyst-filled month of September.

TRADING WEEK AHEAD

The second market-moving catalyst in as many weeks will occur Thursday with the conclusion of the September FOMC policy meeting.

We are expecting the Federal Open Market Committee to vote for more policy accommodation citing Europe, a weak U.S. employment picture, and the pending fiscal cliff as reasons to launch additional stimulus.

This easing likely will likely include an extension of the late 2014 forward rate guidance into 2015, and a new asset purchase program (QE3).

The grim August payroll data may have helped cinched more easing, which may help this central bank-fueled rally to run a bit farther. QE3 is pretty much assured, but it may not help matters much because market expectations for a large-scale asset purchase plan are running very high.

In short, you’ll likely see QE3, but it will not be as big as many are hoping for. In the off-chance the Fed chooses to do nothing, we would expect significant downward pressure on stocks and commodity prices.

Read: QE3 still on the table

Euro watchers will need to keep an eye on Wednesday’s decision by the German Constitutional Court over the legality of the €500 billion European Stability Mechanism (ESM).

The German court is expected to approve the ESM, but it is unclear if there will conditions be applied to the decision. Non-approval by the court would seriously jeopardize the ECB’s freshly launched OMT program.

Beyond the Federal Reserve and the ECB, Tuesday’s release of the July U.S. Trade Balance may show the deficit has shrunk to its smallest level since November 2010.

Later in the week, inflation price data may have increased the most in three years with higher fuel and food costs. Strip those volatile components away and core prices remain at nine-month lows. Retail sales and consumer sentiment data likely both slipped slightly last month.

The only significant Canadian data this week is August housing starts, which are expected to dip slightly from July and June levels. Starts are expected to remain above the 200,000 level.

David Andrews is the Director, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @David_RGMP