Bank stocks have spent the first three months of 2021 ripping higher, as the outlook has brightened on positive vaccine news and the economy reopening. The KBW Nasdaq Bank Index, a measure of large bank stocks, is up roughly 22% year to date, while the SPDR S&P Regional Banking ETF is up nearly 28%. While it might be easy to say the bounceback is complete, I don't think the bank rally will end this year or over the longer-term horizon. Here's why.

1. Strong economic growth ahead

The Federal Reserve recently said it expects gross domestic product (GDP) in the U.S. to grow by 6.5% in 2021, the highest level of one-year growth since 1984. Banks benefit from a growing economy because they help fuel it, lending to individuals and businesses. Many of the larger banks also benefit from their role in the payments ecosystem. Perhaps some of this growth is priced into the recent surge in bank stocks, but we likely won't see banks actually reap the full benefits of this growth until the back half of the year.

At a recent conference, Bank of America (BAC 1.35%) CFO Paul Donofrio said consumer spending through mid-February had grown 5% from last year. However, he said commercial loan balances have declined in the early months of 2021 as large corporations have tapped the capital markets, while loan revolver utilization among middle-market businesses is lower as well. Donofrio also said commercial loan spreads flattened early in 2021. Many banks have also been using GDP projections lower than 6.5% in their models, so the revision upwards and much better loan activity later this year could further fuel bank stocks.

Exterior of a generic bank in a city

Image source: Getty Images.

2. Rising long-term yields

Another positive for the banking sector has been rising long-term yields, as shorter-term yields have remained near zero. This is referred to as a steepening of the yield curve, and it usually benefits banks because they like to borrow short-term money and lend it out long. The yield on the 10-year Treasury note has risen from about 0.93% at the end of 2020 to about 1.67% now, at one point surpassing 1.7%. Mortgage rates tend to follow the 10-year yield, so as this benchmark rises banks are charging higher mortgage rates and making more profit on those loans.

Banks also tend to invest excess liquidity, which they are flush with right now, into longer-term treasuries, so as longer-term yields improve they will eke out more interest income on excess liquidity they invest. Other longer-term yields, like that on the five-year Treasury note, have been ticking up higher along with the 10-year. The yield on the five-year is linked to a lot of interest rates on commercial lending products, which is a more dominant form of lending in banking now, so a rising five-year yield will continue to help banks as well. Bank of America economists recently raised their forecast on the 10-year Treasury yield to 2.1% by the end of 2021.

3. Beating earnings estimates

There is a very good chance many banks will be able to beat the earnings projections set by analysts going into 2021. We already know GDP is projected to increase this year by more than bankers had previously been modeling for. We also now have two more large stimulus bills out in the economy. This added financial assistance should provide a long enough bridge for borrowers to get back into better financial health and make their loan payments. This, in turn, should let banks avoid many of the loan losses they initially projected and then release the massive buildup of reserves they had stored away for those losses, which will juice earnings.

The Fed also recently said that it plans to remove current restrictions on large bank capital distributions by June 30, which will allow most large banks, if not all of them, to increase their dividends and share repurchases in the second half of the year. Analysts and bankers are likely modeling conservatively, which is what they should be doing during an unprecedented event like the pandemic. And their estimates will likely stay conservative until there is even more clarity around credit quality and the economic outlook, but right now things look to be trending in the right direction.

4. More consolidation

Toward the end of 2020, the banking sector experienced a wave of regional bank consolidation, as several larger regional banks took advantage of lower valuations to find inorganic growth opportunities. That wave continued in February when M&T Bank purchased People's United Bank, and there could yet be more to come.

Although longer-term yields are rising, they are still relatively low, because the Federal Reserve's federal funds rate is near zero. That challenges the revenue outlook for banks because the interest they charge on many loans is tied in some way to this federal funds rate. The pandemic also showed banks just how important it is to invest in their digital capabilities. This, coupled with the competitive environment, may lead banks to raise their hands and sell. Valuations have come up considerably with the recent run-up in stock prices, but if credit continues to hold up, consolidation may intensify later in the year. 

Regional banks are also anxious to pick up scale right now in order to better compete with the bigger players. Scale allows banks to spread their operating expenses over a larger revenue base, which typically makes banks more profitable. This allows banks to invest more in their digital capabilities and trade at higher valuations, which ups their bargaining power when it comes to future mergers and acquisitions.

5. Well positioned for the long term

Banks have a lot of potential tailwinds this year, and have already benefited from rising long-term yields and positive reopening and economic news. But the federal funds rate, which longer-term yields and many of the interest rates on their loans are linked to, remains near zero. The Fed may not increase this rate until 2023 or 2024. But when it does, this should benefit much of the banking sector because most banks are asset-sensitive, meaning more of their assets reprice with interest rates than their deposits.

Although it has practically no chance of happening this year, annual reports from the largest U.S. banks show that if the Fed increased its fed funds rate by 1% this year, it would add billions of net interest income to their earnings. This shows how well banks are positioned for the long term right now, especially if they can retain some of the excess liquidity they have built up during the pandemic.