Investors are rotating into financial stocks. The Fed's next move could determine how far the rally runs.

By Frances Yue

Goldman Sachs was among the big banks that reported strong second-quarter earnings earlier this month.

Financial stocks have been among the market's best performers this month, as strong bank earnings, improving capital-markets activity and fading concerns about private credit draw investors back to a sector that has trailed the broader rally all year.

The Fed's next move, however, may determine how much further the rotation can run.

The S&P 500 financial sectorXX:SP500.40 has gained 6.3% in July, putting it on track to be the month's second-best performer, behind energy's 11.7% advance, according to Dow Jones Market Data. Even so, financials remain a 2026 laggard: their 4.1% year-to-date gain ranks ninth among the index's 11 sectors.

That monthlong strength carried the Financial Select Sector SPDR Fund XLF to a record close of $57.60 on Tuesday, as gains in insurance stocks lifted the sector. The fund then fell 2.2% on Wednesday after the Fed held interest rates steady and Chair Kevin Warsh signaled that the central bank may need to tighten monetary policy. XLF ended up 0.6% on Thursday as stocks recovered from the previous session's selloff.

The rally is testing whether financials can become a more durable source of market leadership, and give investors an alternative to portfolios dominated by technology stocks and the artificial-intelligence trade.

"I think the move higher that we've seen this month is well justified," said Brock Weimer, an investment-strategy analyst at Edward Jones, pointing to the bank earnings reported so far.

Still, the market's sharp swings on Wednesday and Thursday underscored how quickly inflation and interest-rate concerns can complicate the bullish case for financials, he noted.

Strong earnings bolster the case for financials

Investors have found fresh reasons to revisit financials as the second-quarter earnings season has gathered pace. JPMorgan Chase(JPM), Goldman Sachs(GS) and Morgan Stanley(MS) were among the large banks reporting strong results earlier this month, helped by improving trading, capital-markets and investment-banking activity.

"Results were definitely pretty strong across the board," Weimer said. Concerns about private credit and the threat AI poses to data-intensive financial businesses have also faded somewhat, he added.

Still, the improving fundamentals of financials aren't yet reflected in their valuations, according to Michael Arone, chief investment strategist at State Street Investment Management.

Based on results and estimates available as of last Friday, blended second-quarter earnings for S&P 500 financial companies were up 19.4% from a year earlier, while revenue rose 12.6%, according to FactSet. The sector's profit margins expanded and ranked third-highest among those of the index's 11 sectors. However, the financial sector still traded at a discount of more than 30% to the broader market, Arone noted.

The case for financials' bull case also extended beyond earnings, according to Arone. Improving merger-and-acquisition and initial-public-offering activity, benign credit conditions, and banks' dividends and share buybacks all add to the sector's appeal, Arone said. Taken together, those factors led State Street to upgrade financials to positive from neutral heading into the third quarter.

The Fed and the yield curve

Despite strong earnings, financial stocks faced risks from renewed rate hikes and persistently elevated inflation. The pressure intensified after the Fed on Wednesday held its benchmark rate at 3.5% to 3.75% for a fifth consecutive meeting, with three policymakers dissenting in favor of an increase.

Futures traders were pricing in a 63.2% probability of a rate increase as soon as September as of Thursday afternoon, according to CME Group's FedWatch tool.

The direction of interest rates matters to banks because they generally pay short-term rates on deposits while earning longer-term rates on loans and securities.

If short-term rates fall faster than long-term rates, the yield curve can steepen, widening the spread between banks' interest income and funding costs. But if the Fed raises rates and deposit costs climb faster than the yields banks earn on their assets, net interest margins could narrow. Persistently high rates could also weaken loan demand and eventually increase credit losses.

That risk cuts against the sector's other supports, said Keith Buchanan, partner and senior portfolio manager at Globalt Investments. If inflation prevents the Fed from cutting rates or forces another increase, banks may have to pay more to retain deposits. Should longer-term rates fail to rise by as much, the spread between what banks earn on loans and pay for funding could narrow, pressuring net interest income.

-Frances Yue

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08-02-26 0800ET