Financial exchange-traded funds (ETFs) have rebounded this year after a prolonged period of volatility. A flattening yield curve was a major concern over the past few years. However, decent global growth, cooling U.S. inflation and a Fed rate cut have now made the space a winner.

Shares of Financial Select Sector SPDR Fund (XLF Quick QuoteXLF - Free Report) are up 20.9% this year (as of Sept. 20, 2024) versus a 20.2% gain for the S&P 500. Invesco KBW Bank ETF (KBWB Quick QuoteKBWB - Free Report) has gained 4.1% in the past week. We expect the space to have more room to run. Let’s find out what’s working in favor of financial ETFs now.

Gradually Steepening Yield Curve

Since banks borrow money at short-term rates and lend capital at long-term rates, the steepening of the yield curve is always a plus for bank ETFs. On Friday, the spread between the 10-year and two-year treasury yield was 0.18 percentage points versus 0.07 percentage points recorded at the start of the week, benefiting bank stocks and ETFs.

Notably, the movement of short-term bonds is more dependent on Fed behavior than long-term bonds. With the Fed enacting its first rate cut in four years in September, short-term rates are likely to fall ahead. This would boost risk-on-trade sentiments and increase long-term rates, which is why a steepening yield curve is expected.

Will History of 1995 Repeat?

Investors should note that as the Federal Reserve embarks on a new rate-cutting cycle, bank investors are drawing comparisons to the lucrative period of 1995 when the banking sector experienced one of its strongest runs in U.S. history.

Back then, the Federal Reserve, led by Alan Greenspan, had successfully engineered a soft landing for the economy following rate cuts, resulting in a banking boom, according to a Yahoo Finance article. In 1995, a broad index tracking the banking sector surged more than 40%, outperforming the S&P 500. This outperformance continued for two more years.

While Mike Mayo, a Wells Fargo analyst, admitted to similarities to 1995, he is cautious about expecting a full repeat of that success. In the three past instances (1995, 1998, and 2019), where the Fed slashed interest rates without triggering a recession, bank stocks initially dipped but finally rallied.

In those years, bank stocks outperformed the broader market several weeks after the first cut. However, in a broader review of six rate-cutting cycles, the banking sector’s outperformance rarely lasted long, except 1995.

Focus on Value in Financial Sector

Financial stocks are undervalued at the current level. The financial sector’s Major Regional Bank segment currently has a forward P/E of 12.62X. This is lower than the P/E of 19.95X boasted by the S&P 500 ETF iShares Core S&P 500 ETF IVV. The dividend yield of the Major Regional Bank segment is 3.24% versus 1.57% possessed by the S&P 500.

Regulatory Landscape: A Mixed Bag for Banks

In today’s regulatory environment, banks are once again gaining influence in Washington, though not all changes are in their favor, per the aforementioned Yahoo Finance article. Agreed, regulation has tightened since the Trump administration.

But banks recently scored a major victory when regulators lessened new capital requirements. However, the Justice Department has scrapped long-standing guidelines for approving bank mergers, which may limit consolidation opportunities.

Mixed Impact of Rate Cuts on Bank Earnings

The impact of rate cuts on bank earnings is mixed. Some lenders, who thrived under high interest rates, may see lower profits, while others who struggled are set to gain. However, the earnings picture of the banking system has remained decent so far.

Leading banks such as Goldman Sachs (GS Quick QuoteGS - Free Report) and JPMorgan Chase (JPM Quick QuoteJPM - Free Report) reported robust increases in investment-banking revenues in the second quarter of 2024. At a recent Barclays conference, some bank executives, including Bank of America CEO Brian Moynihan, expressed optimism about better earnings in 2025.

Any Wall of Worry?

JPMorgan Chase COO Daniel Pinto cautioned that analysts are being too optimistic. Credit challenges are also looming, with Ally Financial CFO Russell Hutchinson acknowledging intensified credit issues in the retail auto business. RBC Capital Markets analyst Gerard Cassidy predicts higher revenues for banks next year but also expects increased loan loss provisions in the coming months, as quoted on the Yahoo Finance article.

Financials ETFs in Focus

Against this backdrop, we highlight a few financial ETFs that are poised for further rally.

US Financials iShares ETF (IYF Quick QuoteIYF - Free Report) – Shares up 21.7% this year.

Financial Alphadex ETF First Trust (FXO Quick QuoteFXO - Free Report) – Shares up 18.4% this year.

U.S. Regional Banks iShares ETF (IAT Quick QuoteIAT - Free Report) – Shares up 14.4% this year.

S&P 500 Financials Sector SPDR (XLF Quick QuoteXLF - Free Report) – Shares up 20.9% this year.

Invesco KBW Bank ETF (KBWB Quick QuoteKBWB - Free Report) – Shares up 19.2% this year.