The Fed Paused Rate Cuts. That's Great News for These 2 Financial Stocks

After three consecutive decisions to lower the federal funds rate, the Federal Open Market Committee (FOMC) paused rate cuts at its meeting this week.

Ultimately, the FOMC decided to hold rates at between 3.50% and 3.75%, citing an expanding economy, stabilized unemployment, and still-elevated inflation.

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The decision to pause rates was widely expected. According to the CME FedWatch survey of interest rate traders, rates are expected to stay put until the June 16-17 FOMC meeting. Of course, this is just speculation.

Technology stocks and growth stocks generally favor lower rates, as do many financial stocks, as lower rates spur mergers and acquisitions and lending. But two major financial stocks would certainly not mind rates staying where they are for a while -- or even rising.

Those would be the two leading custody banks, BNY Mellon (NYSE: BK) and State Street (NYSE: STT).

Why these banks might favor a rate pause

As custody banks, BNY Mellon and State Street hold, protect, and service assets from large institutional investors, asset managers, pension funds, corporations, foundations, mutual funds, wealth funds, and endowments, among others.

BNY Mellon oversees $59.3 trillion in assets, while State Street has $53.8 trillion in assets under custody.

Both of these banks make a majority of their revenue from servicing and other fees paid by clients to oversee the assets. In the fourth quarter, BNY Mellon made about 70% of its $5.2 billion in fees while State Street made about 75% of its $3.7 billion in fees.

But the rest of the their revenue comes from net interest income on things like securities lending, uninvested cash, cash sweeps, and foreign exchange spreads. Last quarter, BNY Mellon made about $1.35 billion in net interest income while State Street made $802 million.

They pay much lower deposit rates than traditional commercial banks because the assets are stickier; its customers aren't there for yield or savings but simply to hold and service. Plus there are high switching fees.

So when rates are higher, BNY Mellon and State Street make higher net interest margins, or spreads. These banks are also less sensitive to interest rate changes and competition from other banks, so they are viewed as a more stable investment in a higher-interest-rate environment.

State Street and BNY Mellon stocks on the rise

After the FOMC decision, State Street stock rose about 2.5% to around $131 per share while BNY Mellon shares increased around 2% to $121 per share.

It is probably because both will continue to see higher net interest income over the next few months if rates indeed stay where they are.

Both stocks are considered buys by analysts. State Street has a median price target of $145 per share, indicating 11% upside, while BNY Mellon's target is $136 per share, suggesting a 13% return.

Also, both stocks are cheap and have been steady growers over the past three years under high interest rates. BNY Mellon has averaged a 34% annualized return over that time while State Street has averaged about 13%.

Dave Kovaleski has no position in any of the stocks mentioned. The Motley Fool recommends CME Group. The Motley Fool has a disclosure policy.