Bank Earnings Start as Lower Rate Impact Debated

Falling U.S. interest rates are good news if you're financing a car, buying a home, or expanding your business. But falling rates are sweet and sour for the major U.S. banks preparing to report third-quarter earnings later this week, and already have raised concerns about bottom-line impact.

When rates fall, worries can mount about banks' ability to continue generating the net-interest income (NII) that's driven so much profit over the last two years. The largest banks open their books starting Friday less than a month after the first Federal Reserve rate cut in more than four years. The Fed's "jumbo" 50-basis-point rate trim on September 18 precedes what the Fed and market participants expect to be a series of further trimming later this year and next.

As a reminder, NII measures the money banks make lending minus what they pay to customers. Banks store money, so higher rates help them make more money just as they help bank customers looking to sock money away. When rates go down, banks make less when they purchase bonds or lend money.

The Nasdaq Bank Index (BANK) chopped around this autumn, losing ground from its late July peak and not recovering fully even after the Fed's rate cut. The financials sector's uncertain trajectory coincided with a drop in the 10-year Treasury note (TNX) yield, which traded below 4% through August and September after spending most of the second quarter between 4.2% and 4.7%. 

It became abundantly clear that falling rates threaten banks' NII in mid-September after a JPMorgan Chase (JPM) executive told investors that analysts' then-current estimate of $90 billion in NII for the company in 2025 was "not very reasonable," CNBC reported. Shares plunged 5% in one day—their worst daily performance in more than four years.

"At the end of the day, lower interest rates mean less NII for these banks, and NII was a windfall," said Kevin Hincks, host of Fast Market on the Schwab Network. "That said, big banks are pretty well-run businesses, and they'll probably do all right."

Falling rates don't just hurt banks on the NII line. It can also signal a slowing economy where less money is moving around, fewer people want to borrow, and credit card balances fall. At the same time, banks have been paying high yields to customers who lock their money up in certificates of deposit (CDs) and money market funds and can't suddenly chop those rates just because they're making less when they lend money out to other customers or buy bonds. CD yields will likely eventually fall along with rates, but in the meantime, banks are caught in the middle.

Additionally, there were signs late last quarter that not all is well with the U.S. economy, including slowing jobs growth and continued weakness in the manufacturing sector. These, along with prices that are up sharply from two years ago for most items, helped lead to the Fed's jumbo cut and continue to make life tough for U.S. consumers. They're starting to show up on banks' bottom lines.

"Slower economic growth means less swipes on credit cards, overall credit card balances going higher, and savings accounts going down," Hincks said. "Last month, Ally Financial reported that car loan demand is slower, and credit is getting poorer." 

Those trends aren't likely isolated to Ally Financial (ALLY) alone. Other regional and smaller banks might also feel the impact.

Enough sour. On the sweet side, lower rates mean banking clients might be more willing to leave their money in bank accounts if Treasury yields and stock dividends fall with interest rates. Dropping rates also ease mortgage levels, which could conceivably shake up the lackluster U.S. housing market and provide banks more customers seeking home loans.

Additionally, rate volatility can sometimes mean more capital markets trading activity to pad banks' bottom lines. However, there are signs that trading activity slowed in the third quarter, which could be another roadblock for coming earnings.

Goldman Sachs (GS) shares plunged in mid-September after CEO David Solomon predicted a decline in third-quarter trading revenue, citing a "more challenging macro environment, particularly in the month of August," media reports said.

"Goldman Sachs said trading revenues will be down 10%, and if Goldman Sachs is down 10% in trading, then so is JPMorgan Chase, and they're the bellwether because they're in every part of the market," Hincks said. "Morgan Stanley and Goldman Sachs are more involved in fixed income trading. Look at JPM stock. It was down $17 at one point in late September from its August 30 high. The bond market has slowed and maybe people are more hesitant."

Some big investment banks that begin reporting this Friday include JPMorgan Chase (JPM) and Wells Fargo (WFC).

Goldman Sachs (GS), Morgan Stanley (MS), Citigroup (C), and Bank of America (BAC) are expected to report early next week.

Beyond the biggest banks, third-quarter earnings growth for the broader financials sector looks like it might be lethargic. As of late September, research firm FactSet pegged third-quarter S&P financials sector earnings per share (EPS) growth at 0.1% compared with 4.6% expected for S&P 500 companies overall. Revenue growth for financials is seen at 4% compared with overall S&P 500 revenue growth of 4.7%. The financials sector includes big banks, regional banks, credit card companies, and insurers.

Still, the biggest U.S. banks often overcome low expectations. Back when second-quarter earnings season began in July, analysts projected less than 5% EPS growth for financial companies, according to FactSet. The sector ended up delivering EPS growth of 17.6%, above average S&P 500 EPS growth of 11.3% that quarter. Sector revenue growth of 4.5% also beat analysts' initial second-quarter expectations of 2.9% revenue growth from financials. However, that revenue growth fell short of the 5.3% SPX revenue growth in the second quarter.

Drilling down into banks and capital markets—the two subsectors of financials that drive much of the results we'll see over the coming days—earnings growth reached 8% and 28%, respectively, in the second quarter, FactSet said. A positive revenue surprise from JPM in the second quarter was an outsized contributor to the better-than-expected financials sector earnings performance.

In sum, 81% of S&P 500 financials companies, which include banks, exceeded analysts' second-quarter EPS estimates and 61% exceeded revenue estimates, according to FactSet.

Net profit margin is also an important element in banks’ earnings reports, and it rose to 18.7% in the second quarter from 16.6% a year earlier. This partially reflects gains in NII over that stretch, so it might be interesting to see if third-quarter earnings show any compression here as NII becomes less of a tailwind.

As of late September, investors built in about a 47% chance of another 50-basis-point Fed rate cut at the next meeting of the Federal Open Market Committee in early November, according to the CME FedWatch Tool. Chances of a 25-basis-point cut are 53%.

The second-quarter featured Goldman Sachs, JPMorgan Chase, and Morgan Stanley reporting solid numbers in trading revenue, with Goldman Sachs saying that its 17% overall revenue gain reflected higher year-over-year numbers for its global banking and markets division. Equity and fixed income trading revenue also rose double-digits at Morgan Stanley. Mergers and acquisitions activity played into Morgan Stanley's strong results, the company said at the time.

Investment and trading revenue is only part of the equation, however. NII, which swelled for many banks when interest rates rose from 2021 through 2023, also likely needs to keep providing a boost. It didn't in the second quarter. Bank of America, for instance, saw sequential NII fall 3% to $13.7 billion that quarter.

NII has been a nice tailwind for banks, but it tends to fluctuate over time depending on the path of interest rates. That means banks still need to focus on basic blocking and tackling to keep their businesses growing. To do this, banks need to attract deposits, make loans, and profit from trading and other market activity like mergers and acquisitions and initial public offerings (IPOs). Those things can grow in importance once banks can't lean so much on NII to make their numbers. 

That's why those results could get a closer look from investors this coming quarter and in quarters to come. Recent declining economic data raise questions about how banks can meet expectations across those metrics, though one month of slower readings isn't enough to represent a trend.

The economy is a wild card for banks the rest of the year. On the one hand, if overall growth slows and the Federal Reserve continues cutting rates this year and next, as the market expects, it could support certain business activities where banks make money like mergers and acquisitions and general borrowing demand from consumers and businesses. Lower rates often support the stock market, too, meaning there could be additional demand for IPOs. Banks are heavily involved in IPOs and mergers and acquisitions, an important source of their revenue.

Things may improve for the sector as the year continues, with financials pulling ahead of the S&P 500 for the full year in terms of projected earnings growth. Financials sector earnings are seen rising 15.1% in 2024, outpacing expected 10% S&P 500 EPS growth for the year, FactSet said late last month.

Earnings season for the biggest banks offers investors a chance to hear CEOs' perspectives on the credit market for consumers and businesses as well as their broader take on the possible path of the U.S. economy. Friday's JPMorgan Chase earnings report will include views from the bank's CEO Jamie Dimon, whose outlook can sometimes move the market. 

Last month, Dimon raised eyebrows when he mentioned that stagflation—a bearish combination of weak economic growth accompanied by inflation—remained a possible U.S. economic outcome. He also hasn't been optimistic about chances for a "soft landing," in which interest rates come down while the jobs market stabilizes. A soft landing is the Fed's goal.

"A lot will trigger off of what Dimon says," Hincks said. "Banking sets the tone for the earnings season because they're the first to come out. Any hesitation or weakness in guidance could hurt."

As always, when the big banks report, it's important to watch each institution's general level of loan activity and the quality of their existing loans. Banks still have a good deal of outstanding loans on their books due for refinancing this year. Falling rates over the last few months could make it easier for customers and business to refinance loans. The recent drop in 30-year mortgage rates toward 6% from peaks near 8% could loosen up the housing market, helping regional banks and some larger banks' consumer lending businesses.

Loan loss provisions, or the funds banks put aside in case loans go bad, grew massively during the pandemic, detracting from industry earnings. But falling rates could allow banks to take money out from under the mattress and be less concerned about loans going bad. It'll be interesting to see if banks start reducing those provisions this quarter and in coming reporting periods, which could boost bottom lines. 

Though big banks get much of the attention, smaller regional banks begin reporting next week and might provide investors more insight into the small businesses and consumers that form much of their customer base. They can often provide ground-level views of emerging trends like home buying and business loans demand.

For the major banks reporting Friday, analysts expect the following, according to Yahoo Finance:

• JPM EPS of $4.02, down 7% from a year earlier, on revenue of $41.79 billion, up 5% year over year
• WFC EPS of $1.28, down 13% from a year earlier, on revenue of $20.4 billion, down 2% year over year
• C EPSs of $1.34, down 18% from a year ago, on revenue of $19.86 billion, down 1.4% year over year