As equity investors have increased their bets against healthcare stocks and electric vehicle manufacturers this year, short sellers have increasingly backed away from financial sector stocks.

The ongoing economic recovery, relatively strong performance from financial sector stocks — including Berkshire Hathaway Inc., JPMorgan Chase & Co. and Bank of America Corp. — and a steepening Treasury yield curve have pushed short sellers to look elsewhere for potential returns, experts say.

Shorting financial stocks "would be very risky with the economy showing strength," said John Stoltzfus, chief investment strategist with Oppenheimer Asset Management.

At the end of May, just 1.57% of financial sector stocks were held by short sellers, the lowest percentage of any of the market's 11 sectors, according to the latest S&P Global Market Intelligence data. By comparison, the S&P 500 had an average of 2.21% of shares held by short sellers, while healthcare and consumer discretionary stocks had an average of 5.13% and 4.57%, respectively.

Short sellers borrow stock and sell it in anticipation of replacing it later at a lower cost if the share price falls. If the strategy is successful, short sellers profit from the difference between the price at which they sell the stock and the price at which they repurchase.

Short selling roiled equities earlier this year when retail traders pushed GameStop Corp. to sharp increases in response to the heavy speculative betting on the retail game company's pending demise.

Financial sector stocks have drawn among the least interest from short sellers since early 2020, competing with utilities and real estate as the least-shorted sector in major U.S. stock markets. Short interest in the financial sector has fallen from 3.1% at the end of January 2020.

"The banks are expected to benefit during the recovery from both the increase in economic activity and from a steepening yield curve generating higher net interest income," said Michael O'Rourke, chief market strategist with JonesTrading.

The financial sector historically outperforms through the middle of an economic expansion as the yield curve steepens, which occurs when long-term bond yields rise faster than short-term yields and investors price in higher growth in the future. The growing gap between shorter and long-term rates allows banks to generate more income by putting cash to work at higher rates.

Matt Weller, global head of market research with GAIN Capital, said short interest in financial sector stocks has dwindled as borrowing and lending conditions have improved since the height of the pandemic. For example, the gap between the U.S. Treasury two-year and 10-year yields have gone from about 10 basis points to over 150 basis points in mid-May, Weller said. The gap between the two- and 10-year yields closed at 123 basis points on June 22. The larger differential allows banks and other financial institutions to earn larger margins from "borrowing short and lending long," Weller said in an interview.

"Given where we are in the economic cycle and the relative outperformance of financial stocks over the last year, short-inclined traders are likely waiting on the sidelines for signs of a flattening yield curve before betting against the financial sector again," Weller said.

Since early February, the S&P 500 financials sector has outpaced the overall large-cap index. Financial stocks climbed as much as 30% on the year in early June and remain up about 19%. By comparison, the S&P 500 is up about 10.9% on the year, while the heavily shorted health care and consumer discretionary sectors are up about 8.5% and 6.5%, respectively.

Still, financial stocks tend to trade at a lower multiple, in a more confined range, than other stocks that tend to draw more short interest, said Steve Massocca, managing director of the Wedbush Equity Management team.

"Therefore, the potential reward is less," Massocca said on why financial stocks tend to draw less short interest.

The limited short attention in the financial sector will likely continue as long as rates remain low, according to Massocca.

The Federal Reserve on June 16 kept its benchmark federal funds rate at near-zero levels June 16, but most Fed officials now see at least one rate hike in 2023, and seven members see the central bank tightening as early as next year. This hawkish shift has roiled government bond markets.

"A change in rates … changes everything, and potentially fast," Massocca said.