Market Perspective for September 5, 2014

Stocks had a mixed week, with the major indexes trading in a tight range. Nevertheless, the S&P 500 did move higher as it gained 0.21 percent on the week. The Dow Jones Industrial Average advanced 0.23 percent, while the Nasdaq climbed 0.05 percent. The Russell 2000 fell slightly, losing 0.35 percent.

The reason for the weakness in the S&P 500 and Nasdaq this week, which bled into the Dow and Russell 2000, was the largest component in those two indexes: Apple (AAPL). The hacking of the company’s iCloud service dinged shares for losses of more than 5 percent at one point during the week.

The big economic news of the week was the European Central Bank’s (ECB) decision to cut interest rates even further for banks. Earlier this year, they cut the deposit rate for banks to negative 0.10 percent. They cut it again on Thursday, to negative 0.20 percent. The prior rate cut didn’t stop banks from keeping money at the ECB, it merely pulled rates lower. The ECB also cut the interest rate it charges for short-term loans to 0.05 percent.

Next month, the ECB plans to start buying some asset backed securities, similar to what the Federal Reserve has been doing with its quantitative easing policy, but to a much smaller degree. The ECB also will not target government bonds, but mortgage, credit and other credit assets from the private economy.

The market responded to the news by selling the euro and sending it sharply lower, down to nearly $1.29. The drop may be the end of a four month sell-off in the euro that took it down from its 2014 high of $1.39. It is likely to bounce as traders were betting on the ECB taking these types of policy steps. Whether a rebound holds is another question. The European economy is not in good shape and the entire eurozone may see deflation. Should the ECB policies not work, there will be more euro selling and more pressure on the ECB to do a Fed-style massive quantitative easing program.

Domestically, the economy remains in good shape. This week we learned the manufacturing PMI for August climbed to 57.9 and the ISM manufacturing index climbed to 59, indicating an increasingly strong economy. Factory orders and motor vehicle sales were up as well in August, and productivity came in line with expectations. Europe is having its effect though: treasury bond yields remain under pressure in large part because European government bonds in Germany and France also have negative interest rates.

Should the ECB fail to spark higher inflation, low and negative bond yields in Europe could keep bond yields suppressed in the United States for an extended period of time. This is good news as the Fed exits from the third round of quantitative easing, as low rates will spur the economy and stock market. Over the long-term, however, it could help spur inflation by keeping rates too low for too long.

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