Bank stocks are racing ahead of the market as they secure cheap sources of funding. The KBW Nasdaq Bank Index, after having lagged the broader market over the past year, is up 7.8% in just the past month, double the S&P 500’s 3.9% gain. The rally is being helped along by banks’ ability to secure more deposit funding, the cheapest of bank liabilities, and which are likely to get even cheaper in coming months, according to the Wall Street Journal.

RBC Capital Markets analyst Gerard Cassidy says that a number of bank stocks look especially poised to outperform in the current environment. He recommends Bank of America Corp. (BAC), Citigroup Inc. (C), Fifth Third Bancorp (FITB), KeyCorp (KEY), and PNC Financial Services Group Inc. (PNC). Quite simply, “Bank stocks need to be owned,” Cassidy recently told clients.

Key Takeaways

  • Bank stocks have outperformed over the past month.
  • Banks are securing cheaper sources of funding.
  • Deposits as a proportion of bank liabilities are at historic high.
  • Banks are likely to lower rates on deposits in the near term.

What it Means for Investors

It may seem a strange time for banks to suddenly take off amid the headwinds weighing on the global economy and the rate cuts by the Federal Reserve. Interest rate cuts can have a negative impact on banks’ net interest margins, especially in low-rate environments.

But margins don’t need to fall if banks can cut their funding costs, and that appears to be exactly what they are doing. Deposits, the cheapest source of bank funding, grew by 5.8% year over year among the largest U.S. banks in the third quarter. Fed data indicates that is the fastest pace of growth since the start of 2017 and has helped push the total proportion of deposits among large banks to 89% of their total liabilities, their highest level since 1985, according to the Journal.

Rates on day-to-day checking accounts ticked up by a median 0.1% from the second quarter. These so-called golden deposits are generally noninterest bearing, meaning they are practically a free source of funding for banks.

Another reason for optimism about bank stocks is their current valuations and the recent rotation from momentum to value. Banks today are much healthier than when they emerged from the 2008 financial crisis, but their shares often have lagged the bull market.

Looking Ahead

To be sure, there are reasons to be cautious. The recent uptick in money being held in checking deposits could be a bad sign, as that is something that usually occurs in recessionary environments. And loan growth has slowed in Q3 at the biggest banks.