By Sinead Carew
NEW YORK (Reuters) - A rare run of outperformance by U.S. bank shares appears to have hit a wall as a spate of soft readings on the economy have tempered bets that the Federal Reserve might raise rates soon.
The S&P 500's bank index is up nearly 9 percent so far in the third quarter, broadly outpacing the wider S&P's 1.4 percent advance. The group, which still lags badly on the year with a decline of 4.6 percent, is on pace for its first quarterly outperformance in more than a year as investors took clues from an increasingly hawkish string of Fed speakers throughout August.
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Low interest rates are a drag on bank profits, and the prospect of even a modest increase in borrowing costs would provide some welcome relief.
"Bank (loans) are increasing, and the possibility of a rate increase means they can reasonably be expected to be doing more business and making more money on it," said Brad McMillan, chief investment officer for Commonwealth Financial in Waltham, Massachusetts.
Paul Nolte, portfolio manager at Kingsview Asset Management in Chicago, said bank stocks "have been moving on Fed expectations – rallying as expectations for a rise increase and falling when those expectations become clouded."
And, as if on cue, expectations have clouded since September kicked off, with data on the job market, car sales and the services and manufacturing sectors all undershooting forecasts.
The probability of a rate hike at the Fed's next meeting on Sept 20-21 have sunk to just 24 percent from around 35 percent in late August, according to the CME Group's FedWatch tool.
Bank stocks have slipped 2 percent since then, and Nolte, for one, thinks they will likely stay soft in the run up to this month's meeting and fall further afterward.
A catalyst for a rebound could come soon in October, however, as the next earnings reporting season gets underway, said John Praveen, chief investment strategist at Prudential International Investments Advisers LLC in Newark, New Jersey.
And after that, the greater possibility of a hike in December will begin to come into focus, bringing with it another potential tailwind for bank shares. CME's FedWatch shows December as a more likely bet, with the current probability around 55 percent.
Still, expect the next couple of weeks to be a choppy affair for the sector - and the market more broadly - as rate hike expectations get whipsawed by some key data. Readings on retail sales, inflation and consumer sentiment are all due in the week ahead, and a final rash of Fed speakers will come into focus Monday.
"It would take a big increase in retail sales, increase in inflation to get the Fed to even think twice (about September)," said Paul Christopher, head global market strategist at Wells Fargo Investment Institute in St. Louis, Missouri.
Friday offered a taste of how the run up to the meeting could play out, with the S&P falling 2.45 percent, its biggest drop since June, after Boston Fed President Eric Rosengren said the Fed faced increasing risks if it waited too long to raise rates again. [nL1N1BL109] Bank stocks performed better than the overall market, but still slid 1.2 percent.
(Reporting By Sinead Carew; Editing by Dan Burns and Diane Craft)