Expectations of regulatory easing are rising, and Wall Street's "smart money" is making the largest bet on bank stocks in a decade

Hedge funds are making their largest bets on U.S. bank stocks in nearly a decade, driving financial stocks to historic highs.

According to data from Goldman Sachs' prime brokerage, last week, hedge funds' net purchases of bank stocks reached the highest level in nearly a decade. This optimistic sentiment, combined with rising expectations for interest rate cuts and the Federal Reserve's announcement that all major banks passed the annual stress tests, collectively propelled the S&P 500 financial sector index to a historic high on Monday.

Market expectations suggest that upcoming regulatory relaxations in the banking sector will serve as a significant catalyst, including revisions to banking regulations that ease capital and leverage requirements. Analysts anticipate that these changes will be implemented in the second half of 2025, allowing banks to manage their loan portfolios more aggressively before the end of the year and into 2026.

Despite limited expected growth for the financial sector during the current reporting period after nine quarters of profit expansion, options traders are still preparing for further stock price increases. The call-put ratio for the Financial Select Sector SPDR Fund (XLF) is hovering near a four-month high.

Hedge Funds Make Big Bets on Bank Stocks

Confidence among Wall Street institutional investors in bank stocks is reaching new heights. Data from Goldman Sachs' prime brokerage shows that hedge funds' net buying activity in bank stocks surged to a near-decade peak last week, indicating strong optimism from "smart money" regarding the sector's outlook.

This optimistic sentiment is widespread among analysts and traders. UBS has listed the large-cap bank stock basket as one of the preferred ways for trading desks to participate in the broader market rally; Wells Fargo's star banking analyst Mike Mayo predicts further gains for bank stocks, and analysts at Bank of America share the same view.

The analyst team at Bank of America, led by Ebrahim Poonawala, stated that the results of the Federal Reserve's stress tests will "inject a strong dose of confidence into the sector."

Regulatory Easing as a Key Catalyst

The anticipated changes in the banking regulatory environment are becoming a significant factor driving stock price increases. The market expects that upcoming banking regulatory revisions will ease capital and leverage requirements, creating more favorable conditions for bank business expansion.

Gerard Cassidy, head of U.S. bank stock strategy at Royal Bank of Canada Capital Markets, stated that the U.S. financial sector is currently his most favored sector globally:

"If the capital requirements that banks must hold are relaxed, it will make lending more profitable for banks, potentially prompting them to lend more aggressively."

Cassidy expects that the relevant changes will be implemented in the second half of 2025, allowing banks to manage their loan portfolios more aggressively before the end of the year and into 2026. He also anticipates that when fixed-rate loans purchased by banks during the ultra-low interest rate environment of the pandemic mature and are renewed, lenders will be able to reprice them at favorable rates.

Additionally, the shift in Federal Reserve policy expectations is also supporting bank stocks. Although higher interest rates are generally more beneficial for banks, the market's expectations for interest rate cuts this year may aid economic development and potentially boost banks' trading businesses Cassidy stated that banks are earning more on their assets while financing costs are declining. This trend is expected to be further strengthened after the Federal Reserve adopts a more accommodative policy.

From a technical perspective, U.S. large bank stocks, represented by the KBW Bank Index, have rebounded more than 30% from their April lows, although they remain 5.4% lower than their peak in 2022.

Slowing Earnings Growth but Optimistic Outlook

Despite the positive catalysts, the banking sector also faces some challenges. After nine quarters of earnings expansion, the financial sector is expected to show weak or zero growth in the current reporting period. JPMorgan Chase, Citigroup, and Wells Fargo plan to announce their quarterly results on July 15, marking the start of a new earnings season.

However, the options market still shows optimistic sentiment. The call-put ratio for the Financial Select Sector SPDR Fund (XLF) is hovering near a four-month high, indicating that traders are preparing for further increases in stock prices.

Piper Sandler's options chief Daniel Kirsch stated:

"We are seeing tremendous interest in the upside potential for bank stocks, driven by regulatory easing and the sector's low implied volatility."