Fed Interest Rate Cut on the Horizon: What it Means for Banks

The Federal Reserve seems to be poised for the first interest rate cut since 2008, when the financial markets and the U.S. economy collapsed. This is a stark change in position for the central bank, which raised rates four times last year and maintained a “patient” stance earlier this year.

The Fed chair, Jerome Powell, in the news conference at the end of two day FOMC meeting earlier this week, said that a clear picture on whether the economy requires easing monetarypolicy is expected “in the very near term.’’

Markets seem to have already factored in that the Fed will cut rates at its July meeting. Per the CME Group FedWatch tool, the odds of a 25 basis point cut in interest rates in July are now almost 72%, a jump from nearly 15% a month ago.

Moreover, a survey of the 17 Fed officials reflect that nearly 50% expect at least one rate cut this year, while seven project two cuts.

This time, the Fed officials kept the key interest rate in the 2.25-2.50% range, while stating that “uncertainties about this outlook have increased. In light of these uncertainties and muted inflation pressures, the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion.”

Trade Worries

Officials acknowledged that the country’s trade policy is creating significant uncertainties, specially the worsening trade war with China. Since the Fed’s last policy meeting in May, trade war concerns have heightened as new tariffs on $200 billion worth of Chinese imports were introduced and trade talks collapsed. Though efforts are on to end the impasse, it is expected to take time.

Further, the Trump administration has plans to impose tariffs on Mexico, and has given Japan and Europe about six months to reach a trade agreement with the United States or face tariffs in the auto sector. All these factors have increased uncertainty among companies, leading to slowdown in factory production and moderating job growth.

Additionally, in its post-meeting statement, Fed officials indicated “that economic activity is rising at a moderate” pace, a downgrade from a “solid” rate that the Fed used at its last meeting statement. Nevertheless, the officials still expect economy to grow at the rate of 2.1% in 2019 and 2% in 2020.

Inflation Concern

Muted inflation is another cause of concern for the Fed. The central bank has failed to hit its 2% inflation target for quite a long time and the expectation of rise in inflation has fallen recently. Even the Fed officials have lowered the target to 1.5% from 1.8% in March.

This is the second time that the inflation target has been lowered. Earlier in March, it was lowered from 1.9% announced in December 2018.

In the post-meeting statement, Fed officials stated “On a 12-month basis, overall inflation and inflation for items other than food and energy are running below 2 percent. Market-based measures of inflation compensation have declined; survey-based measures of longer-term inflation expectations are little changed.”

Impact on Banks

Banks thrive in therising rate environment. So, cut in interest rates will place banks in the most disadvantageous position.

Banks seek to borrow money at short-term rates and lend at long-term rates. If interest rates decline, they will earn less on lending. This would compress net interest margins and hurt bottom-line growth.

Hence, almost all the banks, big and small, including JPMorgan JPM, Bank of America BAC, BB&T Corp. BBT and Zions Bancorporation ZION will be adversely impacted by lower interest rates.

Also, yield curve inversion, (which has already occurred a few times over the past six months) seen as a warning of an impending economic slowdown or even recession, will hurt banks’ financials.

Banks earn net interest income (NII) by charging borrowers higher long-term interest rates while doling out smaller interest rates to depositors. As the yield curve inverts and the spreads between short-and long-term rates narrows, growth in banks’ NII is expected to get hampered.

Another concern, though not directly related to the Fed rate cut, is slowdown in the global economy. This will hurt loan growth as demand is likely to remain muted.

Banks’ financials, which depend on the health of the economy, will be hurt. So, banks’ earnings, which have remained at record levels amid improving economy and higher interest rates, are likely to be affected.

While big banks might be able to overcome this challenging environment given their global operations and diversified revenue streams, smaller domestic banks like Commerce Bancshares, Inc. CBSH, Huntington Bancshares Incorporated HBAN, Zions and Cullen/Frost Bankers, Inc. CFR will likely be more adversely impacted.

Nonetheless, cost savings and streamlining efforts, conservative loan policy, technology advancement and focus on improving other revenue sources are expected to support banks’ financials to some extent. Also, these should aid in overcoming the impending downturn.

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