The journey this year for bank ETFs has been anything but smooth. The largest bank ETF, Invesco KBW Bank ETF KBWB, is off 4.9% so far this year. First, a regional banking crisis caused by the failure of three U.S. banks in the early part of the year and then a flattening yield curve weighed on the bank ETFs. However, the tables are probably turning for the segment as the rates are peaking and the yield curve is steepening. In fact, the ETF KBWB has surged 19.7% in the past six months (as of Dec 15, 2023).

Investors interested to play this catch-up trade may bet on SPDR S&P Bank ETF KBE (up 27.2% past month), KBWB (up 24.5% past month) and First Trust Nasdaq Bank ETF FTXO (up 25.8%). On the other hand, regional bank ETFs include iShares U.S. Regional Banks ETF IAT (up 29.5% past month), SPDR S&P Regional Banking ETF KRE (up 29.9% past month), Invesco KBW Regional Banking ETF KBWR (up 29.3%) and First Trust NASDAQ ABA Community Bank ETF QABA (up 25.2%).

Inside the Steepening Yield Curve

As recessionary fears are ebbing, inflation has been falling and the Fed is likely to cut rates from 2024, a steepening of the yield curve is expected next year. A steepening yield curve is great for bank stocks as the pattern boosts banks’ net interest rate margins.

Shares in U.S. banks rallied strongly last week after the Federal Reserve hinted at potential interest rate cuts in 2024 with the sector returning to its highest level since early March 2023 just before the start of the regional banking crisis. Wells Fargo and BofA Global Research analysts raised price targets across the banking sector in wake of the Fed's dovish pivot last week.

Cheaper Valuation of Bank ETFs

Most bank ETFs have a cheaper valuation than the S&P 500. Invesco KBW Bank ETF KBWB, SPDR S&P Bank ETF KBE and First Trust Nasdaq Bank ETF FTXO have a P/E of 9.38X, 6.85X and 9.49X versus SPDR S&P 500 ETF Trust’s SPY P/E of 17.86X. This indicates that the bank ETFs are undervalued with better growth prospects.

BofA Global Research analyst Ebrahim Poonawala said in a research note issued early on Thursday that the KBW Bank index was still trading at about a 50% discount to the S&P 500 even after outperforming the benchmark since its October lows, as quoted on Reuters.

Rallying stock and bond markets will likely boost large banks segments including wealth management, capital markets and credit according to Rick Meckler, partner at Cherry Lane Investments, who also noted that banks are among underperforming sectors "playing catch-up" in the market, as quoted on Reuters.