After the Federal Reserve started cutting interest rates, are U.S. bank stocks dreaming back to 1995?

As the Federal Reserve cut interest rates by 50 basis points as scheduled, bank investors are beginning to anticipate a return to the glory days of 1995.

However, things don't seem to be that simple...

Revisiting the Prosperous Journey of 1995

In 1995, the U.S. banking industry experienced a period of prosperity, mainly due to a series of interest rate cuts by the Federal Reserve and then-Fed Chairman Alan Greenspan's successful orchestration of a "soft landing" for the U.S. economy.

That year, the banking index (BKX) saw a year-end increase of over 40%, outperforming the S&P 500 index, and this outperformance against the broader market lasted for two years.

However, fundamentally, the banking sector in early 1995 was not optimistic, with some major institutions facing closures:

Orange County, California declared bankruptcy in December 1994, and British Barings Bank collapsed in February 1995; banks with large trading desks were still in the process of recovery (from severe losses caused by the bond market crash the previous year), and commercial real estate lending institutions were still experiencing loan losses from the crisis that began in the late 1980s.

Meanwhile, the U.S. real GDP fell to below 1% in the first half of the year, and the 10-year Treasury yield plummeted by 250 basis points. Fortunately, the yield curve did not invert, allowing banks to profit from the spread between short-term borrowing and long-term lending.

A Strong Start This Year

So far this year, the banking index (BKX), which once soared in 1995, has risen by over 19%, second only to major stock indices. At the same time, another index tracking large banks and other major non-bank financial companies, XLF (Financial ETF-SPDR), has risen by 21%, slightly higher than the major indices.

However, Wells Fargo bank analyst Mike Mayo believes, "History is unlikely to repeat itself, but there may be similarities." While he does not expect next year to be as outstanding as 1995, he stated, "Indeed, there are some similarities."

According to the bank's analysis, in the three instances in history where there was no recession after a Fed rate cut (in 1995, 1998, and 2019), bank stocks typically experience selling pressure after the initial rate cut, then rebound a few weeks later, surpassing the S&P 500 index.

However, from a broader perspective, the performance of the banking sector in the past six rate-cut cycles suggests that its outstanding performance usually does not last long. 1995 was an exception, with bank stocks outperforming the market in the three months following the initial rate cut.

Rate Cuts, Regulations... A Multi-Pronged Approach

Analysis suggests that the expected impact of rate cuts on bank earnings seems to be a mix of pros and cons, with concerns about profit declines for lending institutions relying on high interest rates. Allen Puwalski, Chief Investment Officer and Co-Portfolio Manager at Cybiont Capital, believes:

"There is no doubt that a decrease in interest rates is beneficial for banks. I'm just not sure if this is the same reason as in 1995."

Some analysis points out that besides monetary policy, the industry also benefited from a new era of relaxed regulations in 1995, which began the previous year when then-President Bill Clinton signed a federal law that lifted restrictions on banks opening branches across states, also contributing to the rise of large U.S. banks such as JPMorgan Chase, Wells Fargo, Bank of America, and Citigroup.

Now, despite banking regulations becoming stricter since the Trump administration took office, earlier this month, regulatory agencies relaxed the new bank capital increase plan, halving the requirements for large banks from the initial proposal.

Furthermore, some analysts believe that much also depends on whether the Federal Reserve can achieve a soft landing, allowing the U.S. economy to avoid a recession amid declining inflation. Last Wednesday, Federal Reserve Chairman Powell stated:

"Our goal is to maintain the current strong momentum of the U.S. economy."

Even without a U.S. economic recession, a replay of 1995 requires the support of loan growth and sustained recovery in investment banking business.

At last week's Barclays conference, Bank of America CEO Brian Moynihan and PNC CEO Bill Demchak, among other bank executives, reiterated their expectations for better profits by 2025. However, JPMorgan Chase COO Daniel Pinto expressed concerns, believing that " analysts' expectations for bank earnings in 2025 are overly optimistic"