Wall Street is betting the Federal Reserve will come to the rescue of the trade war-rattled American economy.
Fed rate cuts would aim to put a floor beneath the stock market, boost investor morale and lower borrowing costs for nervous businesses and households.
However, banks might not join the party. Lenders could suffer because rate cuts would hurt their ability to make money on loans.
“If the Fed cuts rates, it’s great for the economy and companies. But it’s not so good for the banks,” said Fred Cannon, global director of research at Keefe, Bruyette & Woods, an investment bank focused on the financial sector.
There’s a 98% chance that the Fed cuts interest rates at least once before the end of the year, according to the CME Group’s FedWatch Tool. That’s up from just 54% a month ago.
And investors don’t think this will be a one-and-done rate cut. There’s a 51% chance that the Fed cuts rates at least three times before the end of the year.
Rate, economic jitters
Much will depend on how aggressively the Fed cuts rates — and whether it’s doing this as a precaution or because central bank officials fear the trade wars are provoking an economic recession.
Banks, by nature, are extremely sensitive to shifts in the health in the underlying economy. Economic booms drive huge demand for banks’ core profit centers — business loans, credit cards debt and mortgages. Recessions, of course, do the opposite. Worse, banks suffer large losses when households and businesses default on their debt.
Bank are also exposed to swings in interest rates. That’s because they make money on net interest income, or the difference between interest paid out on deposits and what’s charged to customers on loans.
Net interest income increases when the yield curve — the gap between short-term rates and long-term rates — is steep. The opposite is true when the yield curve inverts, which is what’s happened recently.
“The worst case for banks is a push-out or failure on trade deals/ratification that leads to both a drop of business/consumer confidence and a series of ‘emergency’ Fed cuts,” Jefferies analyst Ken Usdin wrote in a note to clients.
Usdin said that scenario would not only weigh on bank bottom lines but also drive down bank earnings multiples because of concerns about a slowdown and credit losses.
Rate shocks can hurt banks
Bank profits would only take a minor hit if the Fed lowers rates slowly.
A gradual rate cut of a full percentage point would reduce the average bank’s per-share profit by 4%, according to a Jefferies analysis of rate sensitivity simulations disclosed by banks themselves.
However, a rate “shock,” where the Fed rapidly cuts rates, would knock bank profits down by 10% on average, Jefferies said.
Of course, each bank would respond to a sudden decline in interest rates differently.
Banks with heavy exposure to mortgages could prove to be more resilient, in part because lower rates would encourage stronger demand from homebuyers.
Wells Fargo (WFC), America’s largest mortgage lender, would only see a 4% drop in per-share profits, according to Jefferies. Although the firm noted that Wells Fargo (WFC) still faces “lingering revenue challenges,” a likely reference to the financial fallout from the bank’s various scandals.
At the opposite end of the spectrum is Bank of America, which has a business model that is more vulnerable to pressure on net interest margin.
Bank of America’s (BAC) profits would plunge by 16% under a rate shock scenario, the most of any large US bank, Jefferies estimates.
The good news is that rate cuts would ease fears of bad loans. Floating-rate debt would immediately become easier for companies to pay back.
“The stronger the borrower, the better it is for banks,” said Keith Lerner, chief market strategist at SunTrust.
Soft landing or recession?
But US interest rates are already historically very low. Very few companies and households are complaining about the cost of capital right now. It’s hard to see how a quarter-point rate cut would have an impact.
“25 basis points isn’t going to turn a bad loan into a good loan,” said KBW’s Cannon.
Cannon said that history shows that if there is no recession, bank stocks tend to bottom around the time the Fed cuts.
Rate cuts in a no-recession scenario could help un-flip the yield curve.
“If there’s a recession,” Cannon said, “all bets are off.”