Why Schwab Won’t Benefit From Interest Rate Cuts

As expected, the Federal Reserve cut the US benchmark interest rate on Wednesday. The Fed Funds rate was cut by 50 basis points, bringing most other interest rates down with it. The Fed committee responsible for such decisions also suggests that more rate cuts are on the cards in the near term, which should boost the economy without reigniting inflation. That’s why investors are celebrating the move and the rhetoric.

However, not every company is better off with lower interest rates in this particular economic environment. Brokerage firm Charles Schwab (SCHW 0.97%) probably has more to lose than to gain for the foreseeable future. Investors would be wise to keep their expectations in check. Here’s why.

Schwab’s biggest money maker is under pressure and will be for a while

You know Charles Schwab as a top online broker, but trading doesn’t actually generate most of its revenue. Neither is investment management or retirement plan administration. Ditto for his banking business. Rather, Schwab’s largest source of revenue is interest income, accounting for nearly half of the company’s top line. And that’s it after to pay their own expenses with interest on this income, to be clear.

Surprised? A lot of people are, given the nature of his business. Moreover, it is a cyclical problem that could persist for some time.

Charles Schwab makes more net interest income when rates are higher than when they are lower because spreads — the difference between interest earned and interest paid — are higher when rates are high.

In fact, we are already seeing this phenomenon, but this pressure on profitability is only just beginning if more interest rate cuts are pending.

The image below says part from the story, comparing Schwab’s interest income to its interest expense to determine net interest income. As you can see, net interest income peaked in late 2022, even before interest rates themselves did. As you can see, Schwab’s net interest income has also continued to decline, while overall interest rates have flattened, if not fallen. Most alarming, however, is that market-based interest rates were already falling before Wednesday’s decision. They are likely to continue to decline as well, as the Federal Reserve suggests is on the books.

Data source: Charles Schwab Corp. Chart by author. Dollar figures are in millions.

Here’s why it matters: As of the second quarter of this year, 46% of Schwab’s total revenue is net interest income from offerings like margin loans, cash holdings (including money market funds) and the like. That quarter’s net interest income of $2.16 billion is nearly 30% below the more than $3 billion in Q2 2022, when this source of income accounted for more than half of Schwab’s top line.

Data source: Charles Schwab Corp. Chart by author. The numbers are in the millions.

That number is almost certain to be lower in the future as interest rates continue to fall. It’s already happening, actually. Although margin loan balances have risen since then, Schwab’s average level of interest-bearing assets is near a multi-year low in the first quarter, which is more than 16% below the 2023 peak.

Image source: Charles Schwab Corp. Q2 2024 updated.

In other words, Schwab clients currently hold relatively few investments that generate cash flow for the broker. They hold multiple stocks and bonds, which (at best) generate only a single commission or profit based on the bid/ask spread when entering that trade.

Right stock, wrong time

It’s not all bad. At the very least, Schwab is gaining new customers and raking in more money as a result. At the end of August, it held a staggering $9.74 trillion in client assets, up 20% year over year. Even if only a relatively small portion of these holdings generate recurring income, these holdings are still owned by the broker. He will be able to monetize them when the time is right.

The current economic climate is not one that favors Schwab or any other broker for that matter.

Even though borrowing costs are falling, money is still tight due to inflation…one reason why corporate bankruptcies are now above pre-pandemic levels. Nor is there a lot of must-stock trading activity waiting in the wings, with the overall economy expected to hold up for a while as the post-pandemic effects subside. New investor cash inflows are likely to slow going forward as growth stocks continue to cool. Schwab’s top and bottom lines are likely to reflect this slowdown.

The bottom line? Schwab is still a solid long-term property. In the short term, however, it doesn’t look so bright. Less patient investors may want to consider other, more promising options in the meantime.