Bank stocks are on the cusp of a bear market, and further declines may be ahead as the result of a slowing economy and an inverted yield curve. One popular barometer of bank stock prices, the SPDR S&P Bank ETF (KBE), opened trading down by 21% from its 2018 high, technically a bear market. And another key index, the KBW Nasdaq Bank Index (BKX), wasn't far behind, down 18%. Financial stocks represented 13.3% of the capitalization-weighted S&P 500 Index (SPX) as of the end of February, per MarketWatch, and thus exert a significant impact on the market as a whole.

"The underperformance of the banking sector has really started to accelerate since the Fed went dovish. Banks make money by making loans, so if the Fed is seeing a weaker economy possibly, then loan growth is going to be tough," as Michael Binger, president of Gradient Investments, told CNBC.

Banks May Face More Steep Declines Ahead

(Declines From 2018 Highs)

  • KBW Nasdaq Bank Index (BKX): -18.0%
  • SPDR S&P Bank ETF (KBE): -21.1%
  • JPMorgan Chase & Co. (JPM): -16.5%
  • Bank of America Corp. (BAC): -15.7%
  • Wells Fago & Co. (WFC): -18.7%
  • Citigroup Inc. (C): -19.0%
  • Goldman Sachs Group Inc. (GS): -27.9%
  • Morgan Stanley (MS): -25.0%
  • S&P 500 Index: -4.9%

Source: Yahoo Finance, data as of the open on March 25, 2019.

Significance For Investors

"We're still underweight financials at this point in time. We're still making a series of lower lows and lower highs in here, and from our perspective the recent price action since December has been nothing more than a relief rally," is the opinion of Craig Johnson, senior technical research analyst at Piper Jaffray, per CNBC.

On Friday March 22, the yield on the 3-month U.S. Treasury Bill rose above the yield on the 10-year U.S. Treasury Note. This was the first time since 2007 that the yield curve inverted. The last U.S. recession began in 2007, and an inverted yield curve historically has been a reliable indicator of an upcoming economic downturn.

As economic activity declines, so will the demand for loans, crimping bank profits. Moreover, banks' profit margins on loans tend to rise and fall with the spread between short-term and long-term interest rates, since banks and other lenders raise much of their funds at short-term rates and lend out at long-term rates. In an inverted yield curve environment, that spread turns negative, further reducing banks' incentives to lend.

"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, a brokerage firm based in Orlando, Florida, told The Wall Street Journal. He believes that the Fed's ongoing reduction of its balance sheet, letting its massive bond holdings mature without reinvesting the proceeds, "will have a negative drag on the banks." To be sure, other observers draw an opposite conclusion, given that this reversal of quantitative easing (QE) is putting upward pressure on interest rates, which should be a positive for bank profits.

Looking Ahead

The last instance of an inverted yield curve not only was associated with the start of the last U.S. economic downturn, but also the start of the last bear market in U.S. stocks, as measured by the S&P 500, which was spurred by the 2008 financial crisis. Investors should keep a close eye on whether the latest yield inversion was a fleeting anomaly or the start of a trend.