Bank stocks continued to rise on Wednesday following a blockbuster day, raising hopes that this year’s slump is over and that investors are diving back into the sector.
The gains on Tuesday were large, a much-needed bounce for a sector that many investors have shunned since the banking crisis in the spring. The banks that saw the biggest increases included some regional banks whose stocks got hammered earlier this year: Phoenix-based Western Alliance Bancorp., Cleveland-based KeyCorp and Salt Lake City-based Zions Bancorp.
Banks’ share prices recorded more meager increases on Wednesday, with the KRE regional bank exchange-traded fund rising 1.4% after a jump of more than 7% on Tuesday. The regional bank index is still down about 22% this year, reflecting skepticism amid banks’ waning profitability and worries about the health of their loans, particularly in the office sector.
Many big money managers and generalist investors who sold their bank stocks in March have yet to come back. They appear to be waiting for an all-clear that the sector is due for better days.
“There’s still a lot that needs to be solved — a lot of questions that need to be answered — before they feel comfortable getting back in,” said Tim Coffey, an analyst at Janney Montgomery Scott.
The catalyst for Tuesday’s rally was the latest inflation report, which showed further deceleration in prices and raised expectations that the Federal Reserve may be done raising interest rates. Some investors are eyeing potential rate cuts early next year, anticipating that the Fed will be able to ease off efforts to tamp down inflation by keeping borrowing costs high. Others say that hopes for lower rates so soon are misplaced.
Rate cuts, if they do occur, would generally be welcome news for banks. The rapid pace of the Fed’s rate hikes since March 2022 have made depositors demand higher interest payments, put many banks’ bond portfolios underwater and raised the risk of an economic slowdown.
Where rates go from here is anyone’s guess, but they appear to be “much closer to an inflection point than perhaps many had thought,” Coffey said.
A large chunk of Tuesday’s rally in bank stocks was likely driven by “short-covering,” or investors buying back stocks they had been betting against in order to protect against big losses, said Jeff Davis, managing director at Mercer Capital’s financial institutions group. Several of the stocks that recorded big gains on Tuesday have been heavily shorted by investors.
Some more optimistic investors may be diving back into back stocks because they see an opportunity to snap up cheap companies whose stocks got clobbered this year. The famous bond investor Bill Gross, for example, said this month that the “regional bank falling knife has hit bottom.” Gross said he was buying Truist Financial, KeyCorp, Citizens Financial Group and First Horizon, whose stock prices are all down at least 25% this year even after this week’s rally.
If the U.S. avoids a recession or gets hit by only a mild downturn, bank stocks that have faced major pressure could provide “rocket fuel” for their investors, Mercer Capital’s Davis said. But a sustained rally is unlikely until large money managers become convinced that “the worst is behind the industry,” he said.
Markets are currently pricing in “overly severe scenarios” for banks, according to Truist Securities analyst Brandon King, with investors fretting about banks’ commercial real estate loans and high interest rates pressuring their borrowers. The possibility of the Fed cutting rates in the first half of next year could tamp down those worries, King wrote in a note to clients.
“With that considered, we believe bank investors will be more comfortable adding exposure to stocks at historically discounted valuations,” King wrote.
One effect of lower rates would be to limit the competition that banks face as a result of depositors seeking higher interest payments, he wrote. Another effect would be to help more borrowers stay current on their loans.
Rate cuts would also help banks whose low-yielding bond portfolios went underwater as higher-paying bonds became available — and push more banks to get rid of those bonds without wiping out big chunks of their capital cushions.
Some Fed watchers remain unconvinced that rate cuts will be on the table in the near future.
Markets are “overestimating” the likelihood of rate cuts next year, Larry Meyer, a former Fed governor and co-founder of Monetary Policy Analytics, wrote in a note to clients. In fact, while softer inflation data makes another rate hike less likely, that scenario is not “out of the question,” he wrote.
Fed officials are wary of letting financial conditions loosen up too much and could push back, according to Meyer.
“The ebullient reaction of financial markets to the latest data is partly why we continue to think the market is underweighting the possibility of further Fed tightening,” he wrote.
This content was originally published here.