Artificial intelligence lending company Upstart (UPST 0.96%) announced in a regulatory filing Tuesday that it plans to eliminate 140 hourly employees who helped process loan applications. The company attributed the move to "the challenging economy and reduction in the volume of loans on our platform."

The move all but confirms my suspicions that Upstart might be facing a tough third quarter due to continued pressure on originations from the high-interest-rate environment.

With Upstart's stock down 85% already this year and the company facing another quarter of poor performance, it's clear that Upstart needs the Federal Reserve to slow the pace of interest rate hikes more than ever. Here's why.

Originations are slumping

Upstart is in the business of using technology to originate personal loans, although the company has ambitions to get into other lending areas. The company has developed proprietary credit underwriting algorithms that it believes can assess credit better than traditional underwriting methods such as Fair Isaac's FICO score.

The bulk of Upstart's loan originations are sold to institutional investors, whose funding sources very closely track the Fed's overnight benchmark lending rate, the federal funds rate (it also lets banks and credit unions use its technology to fund loans with their deposits and retain them on their balance sheets). As the federal funds rate rises, so do the interest rates Upstart's institutional investors pay on their capital. With funding now much more expensive, investors want loans that yield more to protect their margins. However, Upstart likely hasn't been able to raise its loan yields as fast as investors' cost of capital is rising, because there's a lag period. First, credit card companies need to raise their interest rates.

The situation has been exacerbated by the fact that the economic outlook continues to deteriorate, which could put much more strain on consumer finances in 2023. Upstart mainly originates loans to near-prime borrowers, who are more likely to default. This has pushed investors to the sidelines until the Fed stops hiking rates so aggressively, therefore increasing their cost of capital. Investors are also likely looking for better visibility into where the economy is headed.

The third quarter could be worse than expected

The conditions I've described are not necessarily new, and we have seen Upstart's business take a big hit as a result. In the second quarter, Upstart originated $3.3 billion of loans, down from more than $4.5 billion in the first quarter. Revenue also dropped by more than 26%, and the company reported a loss of about $30 million.

Management also guided for about $170 million of revenue in the third quarter, which suggested a further ramp-down in originations in Q3. But since then, the Fed has actually gotten more aggressive, and the forward curve implies another 0.75-percentage point rate hike at the Fed's meeting this week and then another half-point hike in December.

We also know that another large online personal lender, LendingClub, which reported its third-quarter earnings results recently, provided weak guidance for the fourth quarter of the year, citing weakening loan demand from investors. And LendingClub originates loans to higher-quality borrowers than Upstart.

This leads me to believe that Upstart will have a worse-than-expected third-quarter earnings report and poor guidance for the fourth quarter as well.

A Fed pivot could help

The one silver lining here is that many are expecting the Fed to soon pivot and slow the pace of its rate hikes. It's certainly not a given, but investors are hoping to glean some information from the Fed's meeting this week.

A pivot would start to help the funding side of Upstart's business because investors and Upstart would have more clarity about where funding costs will top out. However, I am not sure that a Fed pivot immediately helps the credit outlook, because many experts still expect the Fed's massive rate hikes this year to tip the economy into a recession. That could lead to much higher loan losses in the future.

I am still not a huge fan of this stock because I don't like the fact that Upstart's business model is so dependent on the capital markets. Furthermore, the credit outlook for next year is still cloudy. But a Fed pivot this week or soon is badly needed if the company is going to turn things around.