After months of rallying, brokerage stocks took a beating on September 18 as the Federal Reserve decided to keep its bond purchase program unaltered. Charles Schwab (NYSE:SCHW) tumbled almost 6%, while TD Ameritrade (NYSE:AMTD) and E*Trade Financial (NASDAQ:ETFC) ended the day with declines of around 4% and 3%, respectively.
The decline in stock prices of brokerage companies is symbolic of the difficult interest rate environment faced by this industry since the Fed started its quantitative easing (QE) program. Brokerages make a significant portion of their revenue by earning an interest spread on client cash balances. For this purpose, they invest cash balances into higher yield instruments such as consumer loans and long-term securities. However, the yield earned on such loans and long-term securities has been consistently declining over the past few years due to the Fed’s expansionary monetary policy, making it tough for these firms to generate net interest income.
With the Fed showing commitment towards maintaining its bond purchase program until there is a significant improvement in unemployment rates, we expect Schwab, Ameritrade and E*Trade to continue suffering on account of low interest rates for some more time. Our current price estimates for the three companies are around $18, $26 and $14 respectively.
The Fed’s Dovish Stance Is Unlikely To Go Away Soon
Monetary tightening is only possible when the Fed is truly convinced that the economic recovery is sustainable without the bond purchase program. However that does not seem to be the case. Expressing his fears about the effects of monetary tightening on the economy, Fed chairman Ben Bernanke said on September 18 that “the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and the labor market.” 
The Federal Open Market Committee (FOMC), which is responsible for deciding the country’s monetary policy, also agrees with Mr. Bernanke’s assessment of the economy. It reduced its projections for GDP growth in 2013 from 2.3%-2.6% to 2.0%-2.3%.  This only means that there is still some time before the Fed starts tapering its bond purchase program.
Some experts also see the decision to keep the money spigot running as a hand-off from Bernanke to Janet Yellen.  Yellen is a currently the vice chair at the Fed and is believed to be the most likely successor to Bernanke when he leaves office in January. She is also one of the more dovish candidates for the top post at the central bank and is in favor of maintaining the QE until the economy starts showing definite signs of revival. If she is chosen as the new head of the Fed, one can expect the days of low interest rates to continue a little while longer.
Brokerage’s Net Interest Revenue To Remain Under Pressure
Schwab, Ameritrade and E*Trade had average balances of $127 billion, $84 billion and $40 billion in interest earning assets at the end of June 2013. The net interest revenue earned on these assets is likely to remain under pressure until the low interest rate environment continues.
We currently project the yields earned by these companies to remain suppressed over the medium term, and then start rising along with the roll-back of the Fed’s expansionary monetary policy. For Schwab, we believe that the yields could reach around 3.7% by the end of this decade. You can adjust the forecast below to arrive at their own price estimate for Charles Schwab’s stock.Notes:
- Transcript of Chairman Bernanke’s Press Conference Opening Remarks September 18, 2013, Federal Reserve, September 18, 2013 [↩]
- Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, September 2013, Federal Reserve, September 18, 2013 [↩]
- Pimco’s Gross: Failure to taper marks Bernanke handoff to Yellen, MarketWatch, September 18, 2013 [↩]