Can Regional Banks Outperform Large Institutions As Fed Rate Cuts Loom? 'Small Banks Are Plenty Cheap,' But...

As the Federal Reserve approaches a widely anticipated interest-rate cut cycle, traders are evaluating which sectors could benefit the most from lower rates.

One key question on many minds is whether regional banks might outperform their larger counterparts in the coming months.

Since the start of 2024, shares of regional banks, tracked by the SPDR S&P Regional Banking ETF KRE, have risen about 9%, poised to end a two-year losing streak.

However, this performance lags behind that of larger financial institutions, with the Financial Select Sector SPDR Fund XLF up 18% year-to-date. Despite this, the third quarter has seen a notable shift, with regional banks outpacing larger banks by 6 percentage points.

One of the main factors behind the recent outperformance is the growing anticipation of lower interest rates. As illustrated in the chart below, the KRE-to-XLF ratio has recently risen in tandem with a decline in the 2-year Treasury yield, which serves as a benchmark for short-term interest rate expectations.

Chart: Regional Banks Outperform As Traders Anticipate Rate Cuts

A Short-Term Rally Opportunity?

Ed Yardeni, president of Yardeni Research, emphasized 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 highlighted that regional banks are showing a greater sensitivity to interest-rate expectations compared to large banks.

Small banks, in particular, surged 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,” the expert stated, highlighting the dual benefit of lower rates and ongoing economic momentum for regional institutions.

Despite the recent rally, regional banks have yet to recover the valuations they held before the Silicon Valley Bank crisis in March 2023.

Yardeni suggests they could rise at least 5% back to pre-March 2023 levels by the time the Fed cuts rates in September.

Long-Term Outlook Favors Large Banks

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 in regional banks.

Despite this favorable short-term outlook, Yardeni sees the long-term prospects still favoring large banks. Big institutions are expected to benefit from regulatory and policy tailwinds, a backlog of dealmaking demand, and the ability to navigate higher macroeconomic volatility.

Additionally, if the Fed eases the Global Systemically Important Bank (GSIB) surcharge — a possibility reported last month — large banks could have more flexibility to engage in banking activities rather than holding excessive capital in reserves.

Yardeni also expects that a potential relaxation of the Basel III endgame regulatory framework could signal a more favorable regulatory environment for financials after more than a decade of tighter oversight following the Great Financial Crisis.

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