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What a soft landing could mean for bank stocks

The financial sector ETF (XLF) has fallen nearly 5 percent over the last three months as the Federal Reserve interest rate tightening has taken its toll on the sector. Many investors are wondering what this means as we head into 2024 and what it will take to get this sector back on its feet. RBC Capital Markets Managing Director Gerard Cassidy joins Yahoo Finance to discuss how high interest rates have affected the financial sector and what investors should look out for if the central bank achieves its goal.

Cassidy gives historical context, referring to 1994 when the Fed started raising rates, Orange County filed for bankruptcy, and the bond market tanked. He claims if the central bank can "thread the needle" with "what they called back then the goldilocks economy or the soft landing, banks were up 55% in '95. Best single sector in the market," then we should be able to see similar results for next year.

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

Video Transcript

JUIE HYMAN: So Gerard, what do you think is being signaled here? I mean, if I look at a chart of the XLF, as an example, right? It was at its lows for this year at least back in March. Did that then presage the terminal rate already being reached, or, you know, do we still have to go through a bit of a process here?

GERARD CASSIDY: Julie, It's a really good question. And if you look at some of the more banks-- bank-specific ETFs, they bottomed in May when First Republic failed. But that's been the monkey wrench of the curveball in the equation this year is the three bank failures that we all witnessed. Of course, Silicon Valley started it in March with Signature Bank and followed by First Republic. And so kind of threw it off kilter based upon those failures.

But if we now have those failures behind us, we don't expect any other types of failures like that. And so if the Fed really is at terminal rate right now, the stocks are bottoming out. But here's the risk. The risk is they're not able to get inflation under control. And we're now sitting in March of '24, and they're still staring at a 4% to 5% inflation rate. And they have to take the Fed funds rate up North of 7% to bring it under control. That's the bear case for the banks. Now that's not-- you know, that's not a consensus call, and we're not calling for that. But that's the long-tail risk for the banks today.

JOSH LIPTON: What about the economy, Gerard? I'm interested, there's a lot of smart CEOs and economists, they come on Yahoo Finance. And they'll say, listen, they think the Fed is going to stick this soft landing. Others have come on and said, you know, reiterated that's actually pretty rare and tricky. But if there is a soft landing, Gerard, what would that mean for the stocks in your universe? What would it mean for the bank stocks in 2024?

GERARD CASSIDY: Josh, it's the $64,000 question. And it is the critical question, because banks are products of the economy. And it's always easy to say the current period is the most challenging. But the crosscurrents on the economy today are unprecedented. And the reason being is what they did to pull us out of the pandemic. As we all know, the Fed's balance sheet went from $4 trillion to almost $9 trillion during the pandemic. Our US government's fiscal spending, in addition to the regular spending, they gave out almost $6 trillion of payments. So that's stimulus to the economy has been really the big difference between prior periods.

But if they are able to thread the needle on a soft landing, like Greenspan did in 1994, '95, you go back to that period once again, rates went up from 3% to 6% from February of '94 to February of '95. 1994 was a wreck for the bond market. Orange County, California, filed bankruptcy. You had the Mexico peso crisis. It was really bad. Stocks sold off hard, the bank stocks, in the second half of '94.

But once it became apparent in '95 that we had what they called the fact that the Goldilocks economy or the soft landing, banks were up 55% in '95-- best single sector in the market. And so next year, if we get the terminal rate now and a soft landing, bank stocks are going to be big winners next year, because the relative valuations today are the lowest we've seen in decades.