By Himanshi Akhand and Shivangi Lahiri

(Reuters) – Australia’s central bank’s rate path and its effect on inflation will decide whether Australian bank shares can rally in 2025 after a very busy year that has left valuations stretched, analysts said.

The financial sub-index, made up mainly of the country’s biggest lenders, has risen almost 30 per cent this year to mark its best annual gain since 2009, outpacing an 8 per cent gain in the benchmark S&P/ASX 200 index.

The sector’s strong performance was the result of inflows from pension funds and retail investors, who found reassurance in banks’ ability to deliver high capital returns in a weak economic environment.

Stable earnings performance and good asset quality have spurred more funds into banks, while the impact of China’s growth outlook on commodity prices saw a revaluation in the materials sector, several said analysts

“Given the valuation stretch in the banking sector, any weariness in the flow of what has been the dominant driver this year could be a trigger to move down multiple valuation levels back to more normal valuation levels,” the analysts said from Morgan Stanley.

They added that the positioning of its model portfolio remains linked to a scenario that may see a definitive rotation away from Australian banks and expand into other sectors, including resources.

The country’s biggest lender Commonwealth Bank of Australia rose 39% to become the most valuable company on the local bourse.

CBA last traded at A$155.12 per share, well above its average 12-month target price of A$104.37, and has a forward P/E ratio of 27.55, according to data compiled by LSEG.

National Australia Bank rose almost 22% this year, Westpac added 42% and ANZ posted an 11% gain.

Sustaining this upturn would ultimately depend on the rate path of the Reserve Bank of Australia (RBA).

The RBA has kept interest rates at 4.35% for a full year, but opened the door to a cut from February if data plays out as expected.

Since then, markets have raised the odds of a February easing to around 50%, while April is fully priced for a quarter-point cut.

If inflation remains high and short-term rates hold, asset quality issues and a slowdown in consumer spending may emerge, but if rates are cut, investors may find other opportunities on the ASX, already that other companies may benefit from this inflation and rate relief, according to Citi analysts. he said

(Reporting by Himanshi Akhand and Shivangi Lahiri in Bangalore; Editing by Alan Barona)