U.S. banks have underperformed the S&P 500 past month as evident from 9% losses seen inSPDR S&P Bank ETF (KBE Quick QuoteKBE - Free Report) against 6.7% downside in the S&P 500. In the past three months’ timeframe, KBE has lost 12.8% as against 15.3% decline in the S&P 500.

Given a super-hawkish Fed but risk-off trade sentiments due to the Russia-Ukraine war, the yield curve has flattened. The short-term rates have risen lately while long-term rates remained subdued. A decline in long-term bond yields goes against bank ETFs as this lowers banks’ net interest rate margin. Since banks borrow money at short-term rates and lend capital at long-term rates, the steepening of the yield curve is always a plus for bank ETFs.

Notably, the movement of short-term bonds is more dependent on Fed behavior than long-term bonds. With the Fed already enacting 150 bps of rate hikes so far this year with more in the cards, bank stocks had a solid reason to underperform.

A Trend Reversal in the Cards?  

However, bank stocks may be up for a gain on cheap valuation. U.S. financial institutions are trading at bargain-basement prices and continue to present a solid buying opportunity despite near-term market volatility, Oppenheimer said recently as quoted on Barrons.com.

Analyst Christ Kotowski said he sees a favorable fundamental trends for the U.S. financial sector over the course of the year, and believes banks could successfully sail through a challenging macroeconomic environment.

“As long as there are not significant credit issues (which we do not see as a near/medium term issue), banks are much better positioned than most industries to manage through times of market volatility and maintain returns,” he wrote. Financial institutions are “dramatically undervalued,” he said, the Barrons.com article revealed. This is especially true given banks don’t have to deal with physical supply chains, parts shortages, or manufacturing bottlenecks, Kotowski wrote.

Deutsche Bank analyst Matt O’Connor also sees solid second-quarter results from the U.S. banking sector. He said net interest income is likely to be robust and that loan growth will be strong, but recession fears may weigh on share prices, as quoted on Barrons.com. Deutsche Bank analystbelieves that bank stocks are now pricing in a 65- 75% risk of a recession, thus coming across as a cheap and justified bet.

Successful Fed Stress Test

This year, all of the 34 biggest lenders that have been tested have cleared the results. The 2022 stress tests’ focus is on an employment crisis that sends the jobless rate to more than 10% for at least two years, plus a 40% drop in commercial real estate prices.

While this year’s scenarios were devised before the Russia-Ukraine conflict and the current red-hot inflation, they indicate that the banks are well-prepared for a potential U.S. recession, which is predicted for later this year or next year.

A Few Big Banks Raised Dividends

Morgan Stanley, Goldman Sachs, Bank of America and Wells Fargo hiked their dividends after the U.S. banks cleared their annual stress test exercise.

Q2 Earnings Forecast

Per Zacks Earnings Trends issued on Jul 6, 2022, finance sector earnings are projected to decline 20.3% on 3.1% higher revenues in Q2, which follows the 15.6% earnings decline on 3.9% higher revenues in Q1 of 2022. While a major part of the Q1 earnings decline is a result of loan-loss reserves on account of the Eastern Europe situation, tough comparisons in the capital markets business will also be playing a role. Margins in the core banking business have started improving due to rising rates.

ETFs in Focus

Investors pinning hopes on a potential bank rally should keep track of financial ETFs like iShares U.S. Financial Services ETF (IYG Quick QuoteIYG - Free Report) , iShares US Financials ETF (IYF Quick QuoteIYF - Free Report) , Invesco KBW Bank ETF (KBWB Quick QuoteKBWB - Free Report) , Financial Select Sector SPDR (XLF Quick QuoteXLF - Free Report) and Vanguard Financials ETF (VFH Quick QuoteVFH - Free Report) . Goldman Sachs has moderate exposure in the aforementioned ETFs. It is heavy on iShares U.S. Broker-Dealers & Securities Exchanges ETF (IAI Quick QuoteIAI - Free Report) .