Fed Cuts Rates, Signals More Easing: What Does This Mean for Banks?

On Wednesday, at the end of a two-day FOMC meeting, the Federal Reserve kicked off an easing cycle and cut interest rates by 25 basis points (bps) to 4.00-4.25%, marking the end of a nine-month pause. The weakening labor market forced the central bank to change its course despite inflation remaining stubbornly high at 2.9% in August as firms pass on tariff costs to consumers.

The Fed officials anticipate two more rate cuts in 2025, which will bring rates down to 3.50-3.75% by December. Per the latest Summary of Economic Projections, the central bank raised its outlook for economic growth this year to 1.6% from 1.4% projected in June, while affirming expectations for inflation and unemployment at 3% and 4.5%, respectively.

These updated expectations drove investor optimism for bank stocks. Banks, including JPMorgan JPM, Bank of America BAC, First Horizon FHN, BNY Mellon BK and Citizens Financial Group CFG, touched new 52-week highs. While banks generally thrive in a rising rate environment, this time the situation is different.

How Will Lower Rates Impact Banks’ Near-Term Financials?

When the Fed started raising interest rates in 2022 and 2023 to counter persistent inflation, banks tremendously benefited from it. Banks' net interest income (NII), the difference between what banks earn from loans and what they pay on deposits, rose substantially on a decent lending backdrop and solid economic growth. During this period, banks’ non-interest income witnessed a marginal improvement as capital markets-related activities took a major hit, while the asset management business offered some support.

By mid-2023, rising funding and deposit costs started exerting pressure on banks’ NII and margins, given the changing deposit mix toward interest-bearing ones. Higher inflation hampered borrowers’ ability to service debt, putting a strain on banks’ asset quality. Hence, banks such as JPMorgan, Bank of America, First Horizon, BNY Mellon and Citizens Financial Group recorded a slowdown in NII, and their asset quality deteriorated.

Hence, when the Fed trimmed interest rates by 100 bps last year, banks started witnessing a moderate improvement in NII, margins and non-interest income, while asset quality continued to bear the brunt of lingering macroeconomic challenges. 

Now, with the latest rate cut and two more expected later this year, banks seem to be on solid footing for the near term. NII is likely to keep improving on rising loans and deposit balance, a gradual fall in funding costs and asset repricing. Hence, JPM, BAC, BK, FHN and CFG are expected to witness a rise in NII this year and could feel the pressure on NII and margins next year as rates come down substantially by then.

On the non-interest income front, the shift toward easier monetary policy is expected to support client activity, deal flow and asset values. Therefore, non-interest income streams like investment banking & advisory fees, trading revenues and wealth & asset management fees are expected to support top-line growth. Further, lower rates are likely to aid banks’ asset quality, as declining rates will ease debt-service burdens and improve borrower solvency.

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This article originally published on Zacks Investment Research (zacks.com).

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