The Federal Reserve influences more areas of your life than you think. It's not only the body that determines the prime rate that can skew what mortgage or auto loan rates you get, but it also affects investors' risk appetites for stocks versus guaranteed income assets, like bonds.
However, one stock is at the crossroads of both trends, as Upstart (UPST 2.76%) is an aggressive investment pick and a company operating within the lending industry. The past year has been bumpy for Upstart, but it could skyrocket if the Fed cuts rates in 2024.
Upstart's model is more accurate than a traditional FICO score
Upstart's program, powered by artificial intelligence (AI), helps lenders assess creditworthiness using alternative methods like work experience, education history, and other items not typically accounted for by the industry-standard FICO score.
Upstart's proprietary model can assess risk better than the FICO model by painting a more complete picture of a loan applicant. This allows lenders to approve the same number of loans yet see 53% fewer defaults.
For example, an applicant may have a FICO score of 700 or higher yet have an E- Upstart grade (Upstart uses a letter-grade system to convey a consumer's chances of defaulting, with an E- being the lowest possible score). A lender using the traditional FICO model would give this borrower the best rate and assume little risk, while the Upstart model would flag them and either reject them or increase the rate to compensate for the increased risk.
Upstart has seen a 12.9% default rate for these individuals. Compared to the inverse of this example (FICO score below 639 and an A+ Upstart grade) default rate of 5.6%, it shows that Upstart's model works much better than the FICO score.
So, why are lenders still using FICO if Upstart is so much better? Upstart's current product offering is centered around personal and auto loans, so switching half of a lending system over to use Upstart's model is cumbersome. However, Upstart has seen multiple customer wins in personal lending, showing its product is starting to catch on.
Unfortunately for Upstart, the high rates set by the Fed have caused personal loan rates to skyrocket, so consumers aren't as apt to borrow. Furthermore, many cars were purchased and financed at incredibly low rates from 2020 to 2021, and those loans are still working their way through the system. But 2024 may be the year these rates come down.
Will the Fed cut rates in 2024?
The CME FedWatch Tool gives investors the odds of what the Fed will do in its next meeting. Although it expects rates to stay steady in the next two Fed meetings, it gives a 44% chance of a rate cut in March 2024. Fast forward to December 2024, and it expects rates to be in these ranges:
| Target Rate Set in December 2024 | Probability |
|---|---|
| 3.50%-3.75% | 4.40% |
| 3.75%-4.00% | 17.20% |
| 4.00%-4.25% | 29.40% |
| 4.25%-4.50% | 27.50% |
| 4.50%-4.75% | 15.20% |
| 4.75%-5.00% | 5.00% |
Note: Probabilities do not add up to 100% due to the omission of rates with less than 1% probability of happening. Data source: CME Group.
Keep in mind that the current rate is set between 5.25% and 5.5%, so there is a high likelihood we'll see rate cuts of some kind next year (the tool gives it a 0.1% chance the rates will remain the same for the next year). That's fantastic news for Upstart, as substantial cuts could bring potential borrowers out of the woodwork.
If these cuts happen, Upstart's stock probably will rise because its business will ramp up from today's depressed levels. Upstart originated about 114,000 loans in Q3, down from more than 188,000 in 2022 and 362,000 in 2021. Interest rates were much lower in these periods, which allowed Upstart to thrive on volume. Without the low rates, Upstart's revenue plummeted.
Data source: YCharts.
A reversal of the Fed's trend will drastically help Upstart and may well make it into one of the hottest stocks on Wall Street. So, if you're confident that the Fed will cut rates next year, Upstart may be a fantastic stock pick for 2024.
