Why Schwab Won't Benefit From Interest Rate Cuts

As expected, on Wednesday, the Federal Reserve cut the U.S.’s baseline interest rate. The Fed Funds rate was lowered by 50 basis points, pulling most other interest rates lower with it. The Fed committee responsible for such decisions also suggests more rate cuts are in the near-term cards, which should stimulate the economy without reigniting inflation. That’s why investors are celebrating the move, and the rhetoric.

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

Schwab’s top moneymaker is pressured, and will be for a while

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

Surprised? Plenty of people are, given the nature of its business. Moreover, it’s a cyclical problem that could persist for a while.

Charles Schwab makes more net interest income when rates are higher than it does when they’re lower, since the spreads — the difference between interest earned and interest paid — are higher when rates are elevated.

We’re already seeing this phenomenon, in fact, but this pressure on profitability is also just getting started if more interest rate cuts are in store.

The image below tells part of the tale, comparing Schwab’s interest revenue to its interest expense to determine its net interest revenue. As you can see, net interest revenue peaked in late 2022, even before interest rates themselves did. As you can also see, Schwab’s net interest revenue has continued to dwindle, while overall interest rates have flattened, if not fallen themselves. Most alarming, however, is that market-based interest rates were already falling before Wednesday’s decision. They’re apt to continue falling too, as the Federal Reserve suggests that is in the cards.

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

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

This number is almost certainly going to get smaller going forward, as interest rates continue to fall. It’s already happening, in fact. Although margin loan balances are up since then, Schwab’s average level of interest earnings assets is near the first quarter’s multi-year low, which is more than 16% below 2023’s peak.

Image source: Charles Schwab Corp. Q2 2024 udpate.

In other words, Schwab’s clients are currently holding relatively few investments that generate cash flow for the broker. They’re holding more stocks and bonds, which (at best) only generate one commission charge or bid/ask spread-based gain at that trade’s entry.

Right stock, wrong time

It’s not all bad. At the very least, Schwab is winning new customers, and gathering more money as a result. As of the end of August, it was holding a stunning $9.74 trillion worth of client assets, up 20% year over year. Even if only a relatively small portion of these holdings generate recurring revenue, these holdings are still being held by the broker. It will be able to monetize them when the time is right.

The current economic backdrop isn’t one that favors Schwab, however, or any other broker for that matter.

Even if borrowing costs are coming down, money is still tight thanks to inflation… one of the reasons corporate bankruptcies are now above pre-pandemic levels. There’s not a lot of must-have stock trading activity waiting in the wings either, with the overall economy set to be merely ho-hum for a while as the post-pandemic effects wind down. New investor money inflows are likely to slow going forward as growth stocks continue cooling off. Schwab’s top and bottom lines are apt to reflect this slowdown.

Bottom line? Schwab’s still a solid long-term holding. The near term doesn’t look so bright, though. Less patient investors might want to consider other, more promising options in the meantime.