The Best Financial ETF to Buy Before the Next Rate Decision

Regional banks have had a rough go of it over the past two months. The State Street SPDR S&P Regional Banking ETF (NYSEMKT: KRE) reached $74 earlier in February. Since then, it has pulled back to the $63 range, in large part due to geopolitical risks and the volatility in yields.

Regional bank stocks were up about 13% year to date at one point in February. The investment case was that lower anticipated interest rates could expand yield spreads and improve profit margins, loan activity was slowly picking up, and the rotation away from growth and tech stocks could provide an additional boost.

Then the war in Iran happened. Inflation risk has picked up and has priced out almost any possibility of a rate cut in 2026. Multiple key data points, including GDP growth and non-farm payrolls, paint the picture of a slowing U.S. economy. And the question arises of whether regional banks are the opportunity they once were a couple months ago.

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What is the State Street SPDR S&P Regional Banking ETF?

This ETF tracks the S&P Regional Banks Select Industry Index. It includes approximately 150 U.S. regional bank stocks that get equal-weighted.

Within this sector specifically, this is the right way to construct the portfolio. You get exposure to major names, including Zions Bancorp, Texas Capital Bancshares, Flagstar Bank, and Valley National Bancorp, but without the concentration risk that comes with many other market cap-weighted sector funds.

The ETF's 0.35% expense ratio isn't unusual for what you'd pay for a subsector ETF. Its 2.4% yield, however, should be of interest to income stock investors looking to beat the 1.1% yield of the S&P 500 (SNPINDEX: ^GSPC) but avoid some of the risks present in the bond market right now.

The macro environment for regional banks is complicated

Regional banks can be especially rate-sensitive. Their business models aren't the same as the big money center giants, such as Bank of America and Wells Fargo, that are diversified across numerous business lines.

The regionals focus more on business lending in their local communities. That makes them especially vulnerable to economic and borrower-specific risks. If the economy is indeed slowing, as multiple indicators suggest, it could cause lending demand to shrink.

The other big key risk area for regional banks is inflation and interest rates. Three years ago, Silicon Valley Bank and Signature Bank collapsed after they got overextended in long-term bonds. The situation among regional banks is more balanced now, but another inflation and/or interest rate shock could cause real financial trouble for this group.

The good news, however, is that the geopolitical shock from the Iran conflict may ultimately be only temporary. Once a resolution is reached, it's likely we'll see a bullish market reaction that sends oil prices down, yields down, and stocks up. Once this source of uncertainty gets lifted, the market and the Federal Reserve might reconsider rate cuts later this year.

Fundamentals for regional banks are attractive

While none of these risks can or should be dismissed, current valuations make the investment case for the State Street SPDR S&P Regional Banking ETF more compelling.

It currently trades at a forward price/earnings (P/E) ratio of just 10.5, compared to a 20.7 multiple for the State Street SPDR S&P 500 ETF (NYSEMKT: SPY). Its price/book (P/B) ratio is 1.1 versus 4.8 for the S&P 500 ETF. The financial sector traditionally trades at a discount to the S&P 500, but the current gap offers a particularly strong value proposition.

It's time to consider regional banks

A de-escalation of the Iran war could happen this week, or it could happen in a few months. Geopolitical fights tend to be short term in nature, but there's no way of telling how long the Iran conflict could last.

But when it does, the market could reprice the possibility of a rate cut later this year. That's bullish for regional banks who would benefit from a wider spread between short-term and long-term rates. If that happens before the Fed's next rate meeting in April, Chair Jerome Powell could confirm a more dovish lean at that time.

Based on this, investors likely want to consider buying regional banks before the Fed's next meeting at the end of April.

Bank of America is an advertising partner of Motley Fool Money. Wells Fargo is an advertising partner of Motley Fool Money. David Dierking has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.