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The U.S. Federal Reserve announced on December 18 that it will begin tapering its $85 billion per month Quantitative Easing program by $10 billion starting 2014, and the stocks of listed brokerage firms started rallying almost immediately.  Charles Schwab (NYSE:SCHW) was up almost 4%, while Ameritrade (NYSE:AMTD) and E*Trade (NASDAQ:ETFC) rallied by nearly 3% and 2.6%, respectively.
The news is important for the brokerage sector because it portends the onset of a more favorable interest rate environment. The Fed has kept interest rates artificially low for several years largely in order to boost borrowing and increase spending, and prop up the housing market in the U.S., and a decision to taper its QE program suggests that the central bank believes in the sustainability of the economic recovery. Higher interest rates are likely to boost the net interest income of brokerage firms, which can account for as much as 55% of total revenue at some brokerages such as E*Trade.
Net Interest Income Depends On Interest Rate Environment
Most brokerages hold a significant amount of customer cash and deposits on their balance sheets at any given point in time. They pay their clients a small amount of interest on this cash (usually paid at short-term interest rates) and then utilize it to generate additional returns by investing it in loan portfolios and fixed income securities. The income generated in this way – the spread between the interest paid at lower, short-term rates, and the income earned from these returns – is called net interest income.
With a decline in interest rates over the past few years, it had become very tough for brokerages to generate a justifiable return on these assets. The yields on loan portfolios were declining as more people looked to lock in on lower rates by refinancing mortgages, and the yield on fixed income securities such as Treasuries had also reached historic lows due to the Fed’s activities as well as risk-aversion on the part of investors.
With a rollback of the Fed’s QE program, the stage is set for interest rates to start increasing over the next few years.