When interest rates rise, do banks win or lose? Answer: yes. Over the last five years, higher rates have contributed to large financial institutions’ record net interest income, spurring a 70% rally in the Financial Select SPDR FundXLF

. Smaller competitors in the SPDR S&P Regional Banking ETFKRE

haven’t been so lucky, pulling about a third of the returns of their bigger banking peers. But the tide might finally be turning.

Taking it to the bank: Since Nov. 2019,KRE

has gone on a wild ride — collapsing during the COVID-19 pandemic, rallying back amid feverish demand for riskier small and mid-cap companies, and then falling from grace in 2023 after the collapse of Silicon Valley Bank. Since then, they’ve been plagued by investor fears about commercial real estate, slower loan origination, and additional bank failures. But with rates starting to fall, the promise of banking deregulation by incoming Republicans, and the economy holding strong, regional banks have been clawing back to their former highs.

• TheKRE
  fell more than 53% in 2023 during two of the largest bank failures in US history — but from its May 2023 low,KRE
  has rallied over 70%.
• Year-to-date,KRE
  is up 31%, narrowly underperforming theXLF
  ’s 36% return, but both sector indexes have outperformed the S&P 500 and Russell 2000.

It’s a Sale

Regional banks still face uncertainty, especially with the Fed aiming to “gradually” lower rates, leaving the timeline open to estimation as the US continues to tamp down on inflation. Still, the outlook for smaller banks is improving, with these financials benefiting from the shift toward mid-caps and growth stocks in the Russell 2000.

• Investors have been willing to overlook risks and the growing number of problem banks forKRE
  ’s valuation — with a 16.1x price-to-earnings (P/E) ratio, it’s cheaper thanXLF
  (17.9x) and the S&P 500 (28.2x).
• Though its growth is expected to be slower than that of its larger competitors,KRE
  remains attractively priced, with a price-to-book ratio of 1.3x compared toXLF
  ’s 2.4x.

Betting on the banks: With firm fundamentals and the promise of better times ahead, investors spent last quarter betting on a regional bank rebound. Yardeni Research’s CMO, Eric Wallerstein, predicted a “regional bank catch-up trade,” while Stanley Druckenmiller’s Duquesne Family Office invested over $115M inKRE

during Q3 — making it the fund’s seventh-largest holding. These bets have already paid off —KRE

has climbed 16% since the election. And with the ETF still 11% below its all-time highs, it might have more room to run in today’s sweltering stock market.