Since the stock market topped on February 20, the S&P 500 (SPY  ) is 18% lower, the Financial Select SPDR ETF (XLF  ) is 26% lower, and the regional bank ETF (KRE  ) is 34% lower. Notably, both XLF and KRE made lower highs on February 20, while the S&P 500 (SPY  ) made a higher high.

XLF is composed primarily of the mega-cap, Wall Street-oriented bank stocks with more diversified businesses. KRE is composed of regional banks whose earnings are tied more to the old-fashioned business of taking in deposits and lending.

Thus, they are more exposed to the steep decline in interest rates. Also, stocks with smaller balance sheets are more vulnerable to these types of economic storms. Additionally, the carnage in energy markets means that many banks with heavy energy exposure may see steep losses.

Longer-Term Relative Weakness

The S&P 500 exceeded its 2007 highs in 2013. XLF and KRE did not exceed its 2007 highs until late-2017. It's also interesting that both ETFs also made lower highs at the previous market peak in 2007. This relative weakness is due to interest rates trending lower, increased regulatory burdens, and the considerable damage from the financial crisis. It's also a sign that financial stocks after being in a secular trend for much of the past 50 years may now be cyclical stocks.

Clues From Japan and Germany

Another note of caution is to look at the performance of financials in Germany and Japan. Both countries are ahead of the US in terms of debt that is yielding negative amounts and with interest rates that are at zero. In October 2018, the yield on the ten-year U.S. Treasury note was just over 3%. At that point, the Japanese 10-year was yielding 0.17% and Germany's 10-year yield was 0.50%. Today, the 10-year Treasury yields 0.7%, the Japanese 10-year yields -0.04%, and the German 10-year yields -0.80%.

Given the steep fall in commodities, inflation expectations, and uncertain economic damage from the coronavirus, central banks will be dovish for a longer period of time. If inflation remains weak, they are likely to resume quantitative easing, experiment with negative rates, and look to copy Japan with the central bank directly buying corporate debt and even shares in order to prevent deflation. Even if they are successful in lifting inflation, they are likely to tolerate above-average levels of inflation in order to offset years of below-average inflation.

The net result is a continued decline in real interest rates which means a more challenging environment for banks. The effect is evident from the European Financials ETF (EUFN  ) which is trading around 2010 levels. Although, there are no ETFs of Japanese bank stocks available in the U.S., the TOPIX Banks ETF which is an index tracking bank stocks in Japan is back to levels last seen in 2012.