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Best ETFs for 2019: Deflation Holds Down Interest Rates, The XLF Slows

Dana Blankenhorn

Editor’s Note: This article is part of InvestorPlace.com’s Best ETFs for 2019 contest. Dana Blankenhorn’s pick is Financial Select Sector SPDR Fund (NYSEARCA:XLF).

Best ETFs for 2019: Deflation Holds Down Interest Rates, The XLF ETF Slows

At the start of the year I picked the Financial Sector Spider ETF (NYSEARCA:XLF) as the best exchange-traded fund for investors to buy in 2019.

So far, I’m not looking very bright.

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The ETF, which owns big banks and insurers like Berkshire Hathaway (NYSE:BRK.A), JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC), is up just 6.9% for the year, against an 11.7% gain for the S&P 500. Since March 18 XLF has lost half that gain, as financial reporters have reported breathlessly about a “yield curve inversion” predicting recession. 

While I thought the big banks would lead the market higher, with rising interest rates increasing the “yield spreads” that banks get between the price they pay for money and what they can charge for it, the XLF may be leading the market lower.

Why the Pain for the XLF ETF?

Usually, the interest rate on short-term bonds like 30-day paper will fall below the price of long-term bonds like the 10-year note because investors are seeking a safe place for money to hide from the gathering storm.

On March 25, the yield on a three-month note is 2.49%, and on the 10-year, it’s 2.44%. The lowest rates are being paid on bonds that run three to five years, 2.24%. If you plot these rates on a graph against time, the line goes down. That’s an inverted yield curve.

It’s hard for a bank to make money on an inverted yield curve. It’s hard for banks to make money on any loans when rates are below 3%. So bank stocks are under pressure and thus the XLF is falling.

To some people it makes no sense. Unemployment is low, so there should be wage pressures. Government debt is topping $1 trillion per year, which should be raising rates.

What are analysts missing?


Whip Deflation Now

What they’re missing is deflation, downward pressure on prices created by technology and abundance.

Part of the answer is in your hand. Vala Ashfar of Salesforce.Com (NASDAQ:CRM) estimates a smart phone contains what were 60 different devices 10 years ago, everything from cameras and TVs to bank cards, alarm clocks and your PC.

Hyperscale data centers, or clouds, seem like huge energy hogs, but many recycle the heat they generate. PCs that once had to be plugged in the wall now run all day on batteries. Total electricity demand has been flat all decade. So has demand for gasoline.

At the same time, technology is increasing oil and gas supplies — not just thanks to more-efficient fracking but better ways to find new fields. Solar and wind energy now cost less than coal.

Then there’s labor. Emigration peaks when skilled people can reach the global market for their skills. Philadelphia’s not sending Joel Embiid back to Cameroon. Major League Soccer can make big money training South Americans to play in Europe. What’s true for athletes is also true for scientists, engineers and even bankers.

The Bottom Line

The weight of deflation on the global economy is increasing, not decreasing. This directly impacts banking as fintech replaces traditional banking functions. Technology is lowering the cost of processing transactions and of evaluating and servicing loans and insurance policies. Fintech companies are bidding to replace banks entirely.

Big banks are still where the money is, and moving money around is still profitable. But financial intermediaries of all types can be replaced by technology. This, along with other forms of deflation, will continue to put the squeeze on bank, and insurance profits.

But that’s not entirely a bad thing for the economy. Who hates productivity?

Dana Blankenhorn is a financial and technology journalist. He is the author of a new mystery thriller, The Reluctant Detective Finds Her Family, available now at the Amazon Kindle store. Write him at danablankenhorn@gmail.com or follow him on Twitter at @danablankenhorn. As of this writing he owned shares in JPM.

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