There’s a drawback to the Fed rate cut the market so craves

Traders work on the floor at the New York Stock Exchange (NYSE) in New York, U.S., May 30, 2019.

Brendan McDermid | Reuters

Traders are begging the Federal Reserve for several rate cuts this year to salvage an economy they see set to slow significantly because of worsening trade disputes. The market cheered this week when Fed Chairman Jerome Powell opened the door to the possibility.

But if the central bank did cut rates, a group of important stocks to the market would suffer.

Large-cap banks could see their earnings on a per share basis decline by 10%, on average, if the Fed lowers rates by 75 basis points, according to Bank of America Merrill Lynch.

“Lower short-term rates are expected to negatively impact bank earnings,” said Erika Najarian, financials analyst at Bank of America said in a note Wednesday. “Feedback from bank management teams implies mixed sentiment over the ability to cut deposit rates quickly.”

Bank margins could take a hit if they are paying out deposit rates at a higher level than market rates. Their earnings are also hurt when the spread between short-term and long-term rates flattens, a phenomenon that could worsen if the Fed cuts.

Bank stocks already took a hit recently as Treasury yields sank on concerns about a slowing global economy. The SPDR S&P Bank ETF tumbled 10% in May as the yield on the 10-year Treasury note plummeted 14% last month. Part of the so-called yield curve also inverted amid the escalating trade war between the U.S. and China, and now possibly Mexico, sending a recession signal watched by the Fed and experts.

The stocks were notably red on the board Wednesday as the rest of the market continued to rally for second day after Powell said the Fed will “act as appropriate to sustain the expansion, ” essentially opening the door to rate cuts.

Traders are pricing in a more than 90% chance of a September rate cut and about 60% probability of three rate cuts this year, according to the CME FedWatch tool. Bank of America’s economists believe there will be three reductions by early next year. Barclays now also expects a 75 basis point cut this year.

J.P. Morgan‘s earnings could get slashed by 10% by year-end 2020, if the Fed lowers interest rates by 75 basis points, according to Bank of America. Regional lenders including Citizens Financial and M&T Bank could take an even bigger hit from a rate decrease.

“Banks are not expected to benefit as much this cycle (vs. past cycle) from cutting deposit costs given the lower absolute level in rates today,” Najarian said.

However, some banks are better positioned to slash deposit costs following any rate cut. Citigroup and Signature Bank both have above-average deposit costs and larger percentages of money market accounts, so they should have less impact from Fed rate cuts, Bank of America said. BB&T should also outperform due to its merger with SunTrust, the bank said.

— CNBC’s Michael Bloom contributed to this report.

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