With the Federal Reserve gearing up for a widely anticipated interest rate cut cycle, investors are eager to pinpoint the sectors that will benefit most from lower borrowing costs. One key question on everyone’s mind is whether regional banks will outperform their larger counterparts in the coming months.
Since the beginning of 2024, shares of regional banks, as tracked by the SPDR S&P Regional Banking ETF (KRE), have seen a significant rise of approximately 9%, setting them on track to end a two-year period of declining prices. However, this performance falls behind that of larger financial institutions, with the Financial Select Sector SPDR Fund (XLF) experiencing a year-to-date gain of 18%. Despite this, the third quarter has witnessed a notable shift, with regional banks outperforming larger banks by a significant 6 percentage points.
One of the primary drivers behind this recent surge in regional bank performance is the growing anticipation of lower interest rates. As evidenced by the chart below, the KRE-to-XLF ratio has exhibited a recent upward trend, aligning with the decline in the 2-year Treasury yield. This yield serves as a benchmark for gauging short-term interest rate expectations.
Ed Yardeni, president of Yardeni Research, highlights the potential of the financial sector, stating, “We’ve been recommending overweighting the S&P 500 Financials sector. Financial services firms would benefit from the strong growth environment of our Roaring 2020s scenario.” He emphasizes that regional banks display a greater sensitivity to interest-rate expectations compared to their larger counterparts. Small banks, in particular, experienced a surge following Federal Reserve Chair Jerome Powell’s dovish comments at Jackson Hole, with the KRE jumping 5.1% on the day, compared to a 0.9% gain for the broader financial sector ETF.
“Over the short term, there’s a runway for smaller banks to rally as the Fed cuts rates,” Yardeni asserts, emphasizing the double advantage of lower rates and ongoing economic momentum for regional institutions. Despite the recent rally, regional banks have yet to fully recover the valuations they held prior to the Silicon Valley Bank crisis in March 2023. Yardeni suggests that they could experience a further rise of at least 5% to return to pre-March 2023 levels by the time the Fed implements rate cuts in September.
While regional banks present an attractive short-term investment opportunity, Yardeni acknowledges that the long-term outlook still favors larger institutions. Big banks are expected to reap the benefits of regulatory and policy tailwinds, a backlog of dealmaking demand, and their ability to navigate periods of heightened macroeconomic volatility. Additionally, if the Fed were to ease the Global Systemically Important Bank (GSIB) surcharge, as reported last month, large banks could possess greater flexibility in engaging in banking activities, rather than being obligated to hold excessive capital reserves.
Yardeni also anticipates that a potential relaxation of the Basel III endgame regulatory framework could signal a more favorable regulatory environment for the financial sector after over a decade of stricter oversight following the Great Financial Crisis. Currently trading at just 10.7 times forward earnings, regional banks are considered “plenty cheap relative to history.” The valuation gap between large and small firms has widened significantly since last March, offering a potentially attractive entry point for investors seeking exposure to regional banks.
However, it’s important to note that while regional banks are positioned for a short-term rally, Yardeni believes that large banks are better equipped for long-term success, thanks to their resilience, favorable regulatory environment, and potential for further growth.
