U.S. banks have outperformed the S&P 500 past month as evident from 17.9% gains seen in SPDR S&P Bank ETF (KBE Quick QuoteKBE - Free Report) against 12.6% upside in the S&P 500. In the past three months’ timeframe, KBE has gained 12.0% as against 4.6% gains in the S&P 500.

Things are taking a turn for the better for the bank stocks as several U.S. economic data points came in favorable lately. Many investors are believing that markets have priced in the economic recession. The latest data revealed that U.S. gross domestic product shrank for the second straight quarter, meeting an often-cited criterion of a recession.

Moreover, latest data points have eased the recessionary fears too. Inflation in the United States moderated slightly as energy and gasoline prices dropped. This is especially true as the consumer price index (“CPI”) jumped 8.5% year over year in July, down from a 9.1% year-over-year increase in June, which was the fastest increase since November 1981. The producer price index (PPI) showed prices fell 0.5% sequentially compared to expectations of a 0.2% increase.

U.S. consumer sentiment rose in August from a record low earlier this summer, and American households' near-term outlook for inflation fell. The University of Michigan's preliminary August reading on the overall index on consumer sentiment came in at 55.1, up from 51.5 in the prior month. It had touched a record low of 50 in June.

This has given a boost to the risk-on trade sentiments and long-term bond yields. Markets have believed that the Fed might go slow on the rate hike front as inflation cooled. This has lowered the short-term bond yields lately. Notably, the movement of short-term bonds is more dependent on Fed behavior than long-term bonds.

Steepening Yield Curve in the Cards?

In a nutshell, the short-term rates are likely to remain subdued in the near term while long-term rates are likely to remain higher. An increase in long-term bond yields goes in favor of bank ETFs as this increases 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.

Cheaper Valuation?

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 in recent weeks 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 had 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.

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) .