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Bank ETFs have registered upbeat gains this year with First Trust NASDAQ Bank ETF (FTXO - Free Report) adding as much as 31.6% in the past three-month frame. The next winner is Invesco KBW Regional Banking ETF (KBWR - Free Report), which has gained 30.64%. Broad-based financial ETF Vanguard Financials ETF (VFH - Free Report) has also added 17.7% during the period.

We expect the rally could continue based on the below-mentioned reasons, barring some occasional drop-offs.

Fed to Okay Shareholder Value Maximization if Stress Test is Cleared

The Federal Reserve will put an end its restrictions on bank dividends and buybacks for most institutions on June 30 given that they clear the current round of stress tests, the central bank recently announced. Otherwise, restrictions will continue through Sept. 30. The results of this year's test will be released on July 1.

Last year, several U.S. banks — Bank of America (BAC), Bank of New York Mellon (BK), Citigroup (C), Goldman Sachs (GS), JPMorgan Chase (JPM), Morgan Stanley (MS), State Street (STT), and Wells Fargo (WFC) — suspended share buybacks as the coronavirus crisis roiled businesses.

Wall Street's biggest banks were also required to cap shareholder dividends in the third quarter of 2020 to the amount paid in the second quarter as a COVID-19 safety measure, per a CNN article.

Federal Reserve restrictions were enacted last year to boost banks’ capital and to ensure that financial institutions remained ready to lend to those affected by the coronavirus pandemic. The Fed’s decision came at an opportune moment, as banks have been benefiting from higher interest rates.

Steepening Yield Curve

With the Fed being dovish and economic improvements boosting long-term yields, the yield curve will likely steepen ahead. The biggest winner of the steepening yield curve is the financial sector.

As of March 25, 2021, the 10-year benchmark U.S. treasury yield was 1.63% versus 14 bps of the 2-year treasury yield. Meanwhile, the 10-year treasury yield was 1.45% at the start of the month versus 13 bps of the 2-year treasury yield. This led to a rise in yield spread by 17 bps this month, resulting in a steepening yield curve.

As banks seek to borrow money at short-term rates and lend at long-term rates in a steepening yield curve environment, banks will earn more on lending and pay less on deposits, thereby leading to a wider spread. This expands net margins and increases banks’ profits.

Undervaluation

Bargain hunting could also lead to some gains in bank stocks. The forward P/E of Banks - Major Regional is now 13.16X versus 21.27X of the S&P 500. Financial - Investment Bank has a forward P/E of 13.59X, Financial - Savings and Loan has a forward P/E of 13.49X, Financial - Consumer Loans has a forward P/E of 9.63X, Financial - Investment Management has a P/E of 11.68X, and Financial - SBIC & Commercial Industry has a P/E of 10.74X. Such numbers point to the broad-based undervaluation of the banking sector and some room to rally.

Earnings Growth Potential

As of now, the Zacks Earnings Trend predicts a 75.9% rise in Q2 earnings and 0.9% expansion in revenues from financial services companies. If the virus crisis is tackled carefully (which may require much caution given the global rises in COVID-19 cases), a 2020-like crisis will likely be avoided in 2021.

Global vaccination has started, which should provide some support to the ongoing health crisis, even if there is a rise in cases. Hence, bank ETFs may register decent gains in the medium-term on moderate economic growth.