Why Schwab won't benefit from interest rate cuts

As expected, the Federal Reserve cut the benchmark interest rate in the US on Wednesday. The benchmark rate was cut by 50 basis points, which pulled most other interest rates down. The Fed committee responsible for such decisions also indicated that further rate cuts are on the horizon in the near future, which should stimulate the economy without rekindling inflation. Therefore, investors are celebrating this move and the rhetoric.

However, not all companies are better off with lower interest rates in this particular economic environment. Charles Schwab (SW -0.70%) has more to lose than gain in the foreseeable future. Investors would be wise to keep their expectations in check. Here's why.

Schwab's biggest moneymaker is under pressure and will remain so for a while

You know Charles Schwab as a leading online broker, but trading does not make up the majority of its revenue. Neither does investment management or pension plan administration. The same is true for banking. Schwab's largest source of income is interest income, which accounts for almost half of the company's revenue. And that is after To be clear, it pays its own interest expenses from these revenues.

Surprised? Given the nature of the business, many people are. Moreover, it is a cyclical problem that could continue for a while.

Charles Schwab earns higher net interest income when interest rates are higher than when they are lower because spreads (the difference between interest income and interest payments) are higher when interest rates are high.

In fact, we are already seeing this phenomenon, but the pressure on profitability will only just begin as further interest rate cuts are imminent.

The picture below shows Part of history by comparing Schwab's interest income to its interest expense to determine its net interest income. As you can see, net interest income peaked in late 2022, even before interest rates themselves did. As you can also see, Schwab's net interest income has continued to decline while overall interest rates have flattened, if not fallen themselves. But what is most alarming is that market-based interest rates were already falling before The decision will be made on Wednesday. They will probably continue to fall, as the Federal Reserve suggests.

Data source: Charles Schwab Corp. Chart by author. Dollar amounts 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, generated through offerings such as Lombard loans, cash holdings (including money market funds), and the like. This quarter's net interest income of $2.16 billion is nearly 30% lower than the more than $3 billion it generated in the second quarter of 2022, when this revenue stream accounted for more than half of Schwab's revenue.

Data source: Charles Schwab Corp. Chart by author. Figures in millions.

That number will almost certainly get smaller in the future as interest rates continue to fall. In fact, that's already happening. Although margin loan balances have risen since then, Schwab's average level of interest-earning assets is near the first quarter's multi-year low, which is more than 16% below the 2023 peak.

Image source: Charles Schwab Corp. Q2 2024 Update.

In other words, Schwab's clients currently hold relatively few investments that provide the broker with cash flow. They hold more stocks and bonds that (at best) only yield a commission or a profit based on the bid-ask spread when entering the respective trade.

The right stock at the wrong time

It's not all bad. At least Schwab is gaining new customers and making more money as a result. At the end of August, the company held $9.74 trillion worth of customer assets, up 20% year over year. Even though only a relatively small portion of these holdings generate recurring revenue, these holdings are still held by the broker. It will be able to monetize them in due course.

However, the current economic situation does not favor Schwab or any other broker.

Even though borrowing costs are falling, money is still tight due to inflation…one of the reasons corporate bankruptcies are now above pre-pandemic levels. Must-have stock trading activity is also off the charts, as the overall economy will be sluggish for a while while the post-pandemic impact fades. Inflows of new investor money will likely slow going forward as growth stocks continue to cool. Schwab's revenue and earnings numbers should reflect this slowdown.

Conclusion? Schwab is still a solid investment in the long term. However, the short term is not so rosy. Less patient investors may want to consider other, more promising options in the meantime.