Bank stocks already were down sharply from their record highs, partly due to the negative implication for profit margins from the dovish policy reversal by the Federal Reserve. Then came the recent escalation in the U.S.-China trade war, which threatens to dampen global economic growth, and thus the demand for business loans, pushing bank stocks down yet further.

“Bank stocks are generally a way that investors express their view on the health of the economy,” as R.J. Grant, director of equity trading at investment banking firm Keefe, Bruyette & Woods told The Wall Street Journal. “We’ve had a pretty big rally this year in those shares, but now that tensions are dialed up, everyone is worried about global growth and how that will affect all banks,” he added. The table below shows how far shares of the big six U.S. banks, as well as KBW's widely-followed index of bank stocks, have dropped from their highs.

Big Bank Stocks Still Trade Below Record Highs

(May 14, 2019 Close vs. 52-Week High)

Source: Yahoo Finance

Significance for Investors

Given that banks' revenues and profits tend to have a positive correlation with the level of interest rates, the Fed's announcement that it plans to take a pause on interest rate hikes already was a negative development for their prospective earnings. In particular, since banks tend to acquire funds at short-term rates, paid on deposits and short-term debt, while lending mainly at longer-term rates, a generally flat yield curve, which exists in the current macro environment, is another negative for bank profits.

The yield on the 10-Year U.S. Treasury Note, a key benchmark rate against which the prices of a wide variety of business and consumer loans are set, fell below 2.4% during intraday trading on Monday, May 13, 2019 for the first time since March, the Journal reports. The 10-Year T-Note yield closed at 2.414% on May 14.

Adding to the gloomy outlook for bank profits is the renewed U.S.-China trade conflict, with its implications for lower GDP growth and thus decreased demand for loans. As business activity slows, so does the need for business financing, and this reduces both the sales volume and the price of banks' key product, loans.

“The banks are key components to our economy, so much that if they don’t do well, they’re a drag on the market and the economy as a whole,” as Ed Cofrancesco, CEO of International Assets Advisory LLC, an Orlando, Fla.-based brokerage firm, told the Journal in another report.

Looking Ahead

A countervailing force is the Fed's long-term commitment to unwinding its massive balance sheet of bonds accumulated pursuant to its policy of quantitative easing (QE), initiated to combat the Great Recession of 2007-09 and stem the financial crisis of 2008. By letting these bond holdings mature without reinvesting the proceeds, the Fed is withdrawing liquidity from the bond market, putting some upward pressure on interest rates in the process. However, while some bond market bears predicted that this policy reversal would send interest rates soaring, that has not happened yet.