Despite the Federal Reserve’s recent pivot toward easier policy, the financial sector has struggled to keep pace with its peers. Investors are left asking why banks and other financial firms have fallen behind in a market rally that seemed primed to reward them.

Recent Underperformance of Financials

Over the trailing six months, financial stocks posted a marginal gain of only 0.1% against a slightly negative broader S&P 500. This contrasts sharply with sectors such as communication services, which gained 7.3% in the same period, and consumer staples, up 3.1%. The financials’ performance gap is even more striking when considering its role as the second-largest S&P 500 weight at 14.3%, just behind big-cap technology.

Year to date, financials have gained 26.1% over the last 12 months—outpacing the S&P 500’s 14.4% return—but that strength dissipated recently. In contrast, technology stocks returned 14.6% and energy plunged by 13.0% over six months. The discrepancy highlights a divergent market leadership trend that leaves financials at the back of the pack.

Macro Context and Rate Dynamics

Through 2024, a prolonged period of rate hikes bolstered bank net interest margins, as borrowing costs rose. However, the Fed’s decision to cut rates beginning in the second half of 2024 has introduced a new dynamic: lower short-term rates typically squeeze margins, even as they support loan growth.

Market-driven long-term yields, though, have not fallen in lockstep. In some instances, they have ticked upward, creating a tension between policy easing and market sentiment. Forecasts call for two more Fed cuts by the end of 2024 and four additional cuts in 2025, potentially taking the federal funds rate down to 4.5%. While these cuts may reduce credit risks over time, the immediate effect is substantially compressed net interest margins.

Sector-Specific Challenges

• Commercial real estate pressure: Higher-for-longer rates elevate refinancing risks and credit stresses.
• Credit quality scrutiny: Non-performing loans and capital adequacy remain investor concerns.
• Margin and growth trade-offs: Easier policy may spur loan demand but limit profitability.

These headwinds are compounded by a slowing global economy—OECD forecasts point to growth sliding from 3.1% in 2024 to 2.9% in 2025. Even if the U.S. avoids a recession, tepid growth weakens the support that financials typically enjoy in robust expansions.

Looking Ahead: Outlook and Catalysts

• Fed easing benefits: Lower rates could reignite borrowing and deposit growth over time.
• Sector rotation potential: As confidence returns, capital markets and investment management may lead a rebound.
• Selective subsector strength: Insurance and wealth management may outperform traditional banks.

Analysts remain cautiously optimistic. Many expect a volatile S&P 500 environment through 2025, describing it as a “pause” year with single-digit gains. Financial stocks could outperform if earnings estimates stabilize and rate cuts materialize as forecasted.

Summary Table: Performance Comparison

The table below highlights recent sector returns and relative weights in the S&P 500 as of early June 2025.

Conclusion

Financials’ recent lag reflects a blend of mixed policy signals, cyclical headwinds, and uneven subsector performance. While the sector boasts strong long-term returns, the near-term challenges of margin compression and credit risks have weighed heavily.

Looking forward, the path to outperformance lies in a balanced Fed approach, stabilization of market yields, and renewed confidence in credit markets. Investors who navigate these dynamics—with an eye toward reasonable returns from U.S. assets and selective subsector plays—may find that the financial sector’s current underperformance is a precursor to significant opportunity.