Image: iStock.com/Willowpix
Executive Summary
1. The Federal Reserve gets into the payments business. On August 5, the U.S. Fed announced the 4-to-1 result of a vote of its governors to establish a real-time payment and settlement service to be called FedNow. A consortium of 25 major U.S. banks has been building a real-time settlement system called “The Clearing House” since 2017, at a cost of more than $1 billion. Critics immediately noted that the Fed’s entry into the settlement space was an overreach of its mandate, and that it could end up actually retarding the adoption of real-time settlements by the small banks which supposedly it set out to protect. In a political climate where suspicion of big banks continues to be rife, the Fed’s action seemed to some to be uncomfortably political. We simply observe that the Fed’s political neutrality is an ideal that has often been compromised in the past, and should not be taken for granted.
2. Reassessing the trajectory of interest rates. The much-watched spread between two- and ten-year U.S. Treasury bonds briefly inverted on Wednesday and remains flat as of this writing. Most analysts (and we agree) anticipate two further Fed rate cuts this year, and more to come in 2020. We remind readers that an easier Fed stance was part of what enabled markets to rally earlier this year. Now this easier stance is manifesting, in spite of the sometimes inept communication style of Fed Chair Jerome Powell, and in spite of the trade war that continues to unfold between the China and the U.S. (as well as others of China’s global trading partners). Looking beyond the current correction, therefore, we see the prospect of further appreciation for U.S. stocks in the remainder of the year.
3. Market summary. There are always plenty of reasons for a correction, and for the current one, weak global economic data, trade war escalation, and now the inversion of the yield curve are leading the pack. We remain constructive on U.S. stocks, particularly as the correction runs it course and some prices for high-quality growth companies become more attractive. We do not see good opportunities outside the U.S. at present. Gold continues to be a major focus of interest for us, with many fundamental factors underlining what we believe is gold’s likely further appreciation in 2019.
The Fed Steps Into Real-Time Payments
On August 5, the U.S. Federal Reserve announced that its governing board had voted four to one to back the creation of a real-time, round-the-clock payment and settlement service, to be called FedNow. The goal of this service would be to set up an infrastructure to allow payments between banks to settle instantly. This would mean, for example, that your paycheck would clear immediately, instead of four days after you deposit it.
In an era in which Millennial and Gen Z consumers are used to splitting tabs using PayPal’s [
In spite of the governors’ vote, though, the U.S. actually isn’t that far behind the curve. A consortium of 25 big U.S. banks has already invested about $1 billion in a system called “The Clearing House,” which has been running since 2017. It covers half of all accounts, and aims to cover everyone by 2020. Although created by big banks, it has pledged not to discriminate against smaller and community banks; it charges sending banks a flat 4.5 cents and receiving banks nothing. It has pledged to give volume discounts to large banks only to defend its market share from the Fed’s competing system. (Ironically, smaller banks could end up having to pay more as a consequence of the Fed’s intervention.)
This has led some, including dissenting Fed governor Randal Quarles, to question what the Fed is doing. They note that the Fed’s announcement of its proposed system, which will not be operative until 2023 or 2024 even according to its own timetable, is likely to slow complete adoption of instant settlement by smaller banks. Other critics note that the Fed’s foray into this market function contradicts its own statutory purpose; the 1980 Monetary Control Act allows the Fed to develop payment services only if “other providers alone cannot be expected to provide with reasonable effectiveness, scope, and equity.”
It’s hard to know what exactly the Fed is up to, but we do note that this action is taking place in the context of political activism that tars “big banks” with a broad brush, including particularly Elizabeth Warren’s proposed amendments to the Expedited Funds Availability Act of 1987 that would force banks to allow customers to draw funds as soon as they are deposited. In short, the Fed’s action does seem to be politically colored. Ms Warren and others who are concerned about consumers facing overdraft fees may believe that this payment system will eliminate banks’ abilities to charge such fees; they will probably be surprised by banks’ resiliency. It is also very possible that the Fed’s entrance will actually end up slowing innovation in payments, by increasing regulatory uncertainty.
We have noted before that the Fed’s political independence is not the monolithic, historically consistent bedrock that many think it is or would like it to be. A politically independent Fed is a good ideal that has frequently been violated in the past, and we should not imagine that it will never be challenged again in the future.
Investment implications: The Federal Reserve’s relative political neutrality in recent years has been praiseworthy, but is not a sure indication that this neutrality will continue in the future. The Fed has been subject to political pressures in the past, and will likely be again in the future.
Markets Reassess the Fed’s Interest Rate Trajectory
The widely watched two-to-ten-year U.S. Treasury interest rate curve inverted briefly on Wednesday, and remains essentially flat as of this writing. The yield on the longest-dated Treasuries fell to all-time lows. The backdrop, we trust, is well-known to our readers: anxiety about trade wars, fears about slowing global growth, and now, the supposedly prophetic yield-curve inversion suggesting that recession is growing closer.
On the interest-rate front, we simply note that Wall Street analysts increasingly believe that not just one, but two further 25-basis point rate cuts lie ahead in 2019, and more are likely in 2020. The bull case for stocks in 2019 was that rates would fall and monetary policy would ease; and now rates have fallen and are likely to fall further.
We note also, as we have noted in the past, that yield curve inversion is rarely an indication that recession is truly imminent. There is a wide variation in the gap between the initial inversion of the 2/10-year yield curve and the eventual market top, but on average, it is 12 to 24 months, with a significant gain still to be had in stocks.
A Relationship That’s Grown A Little Tougher
Source: Xinhua
We read another significant comment in The Wall Street Journal on Tuesday, which pointed out that President Trump is not just beating at the air as he continues to call out the Fed’s “tightening.” With the Fed’s balance-sheet runoff ended early, and a rate cut already done and more likely to come, how could the President be correct in his accusation? Simply because the Fed’s balance-sheet adjustment is still continuing, albeit in a less observable form. As mortgage-backed securities and longer-dated Federal Reserve paper mature, they are being replaced by shorter-duration Treasuries. In short, the risk that the Fed assumed during its post-crisis asset buying is indeed still being unwound on autopilot — and will be for decades, on this schedule (the last mortgage-backed securities that the Fed holds will mature in 26 years). That’s less risk that the Fed is absorbing and holding… and more risk that the market must absorb and hold. Under present conditions, perhaps that has something to do with the rush to safety that has compressed yields for longer-duration Treasuries.
Will the Fed respond? The evidence is that it is beginning to do so, even though Fed Chair Powell seems to have a hard time communicating with markets in a way that eases their troubled minds.
Investment implications: With further easing now even more likely ahead from the U.S. Federal Reserve, we believe that market sentiment will eventually reflect it when the current correction has run its course.
Market Summary
The U.S.
A correction is underway in U.S. stocks, as stock and bond markets price in trade war and recession risk and investors seek safe havens.
We remind readers that part of the generally accepted bullish thesis at the beginning of the year was that a more accommodative Fed was on the way. In spite of his apparent inept communication, Fed Chair Jerome Powell has begun to deliver on that anticipation, and the consensus is that he will deliver still further in coming months. Additional rate cuts seem likely to most market participants, and to us. So in the midst of a correction — when what was “natural, normal and healthy” is actually happening, and is therefore much more alarming than when it was just a possibility — investors should remember that it is likely to run its course and be followed by a rally, and should have their buy list ready.
We believe the market still wants growth, and so our interest remains focused on U.S. growth companies, particularly in tech industries with strong tailwinds.
Gold and Cryptos
Gold continues to be a major focus of interest, and has been performing well during the current correction. For many clients, we have increased allocations to both bullion and gold miners whose reserves lie in safe, law-respecting jurisdictions. We’ve been telling you since last year that 2019 was likely to be a strong year for gold, and our conviction continues to strengthen. The present rally was underway before the fears undergirding the current correction had come to a boil, and we believe that there is significant fundamental underpinning that makes gold’s rally feel different from a volatility-driven spasm. The second-quarter report from the World Gold Council outlines some of the reasons:
- Overall demand continues to trend higher, with a slight acceleration from the first quarter, and demand is still outstripping supply growth;
- Central bank purchases, especially from developing-market central banks, continues to be very robust, and is accelerating. This is likely a “structural hedge against global economic uncertainty,” and given the policy-driven nature of central bank buying, unlikely to slow suddenly.
- Emerging-market central banks may be seeking indirect dollar exposure by holding gold — which is denominated in dollars — rather than U.S-backed financial assets such as Treasuries;
- Gold ETFs are showing strong inflows;
- The increasing proportion of negative-yielding securities will keep incrementally pushing savers into gold;
- Individual bullion buyers are not yet strongly in the mix, as they usually are when a bull run in gold is nearing maturity.
We believe that for all these reasons, gold can continue to appreciate in 2019.
Bitcoin remains interesting, and our only real focus among cryptocurrencies. It has been consolidating after its appreciation so far in 2019. Bitcoin cannot yet function in the way that gold does in a risk-off atmosphere, not least because the market remains opaque and, we believe, still vulnerable to manipulation. Still, we continue to observe bitcoin closely.
Thanks for listening; we welcome your calls and questions.
Equities Contributor: Guild Investment Management
Source: Equities news
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