Why Did U.S. Bank Stocks Plunge This Week? Bank of America's Warning Was Only the Trigger—Inflation Is the "Invisible Killer"

According to Zhitong Finance APP, the Federal Reserve raised interest rates as expected on Wednesday and sent a hawkish signal that further rate hikes may occur within the year. The KBW Bank Index closed down 2.9% that day, the largest single-day drop since February, with the weekly decline expanding to 5%. The sell-off in bank stocks this week is the result of multiple pressures: cautious earnings guidance released by Bank of America (BAC.US) CEO directly ignited market concerns about the weakening fundamentals of the banking sector, while deeper causes point to persistent stubborn inflation, abnormal changes in the rate structure, and uncertainty in the global debt market.

Direct Trigger: Bank of America CEO's Conservative Guidance Drags Down the Sector

The immediate trigger for the bank stock sell-off this week came from a statement by Bank of America's Chief Executive Officer, Brian Moynihan, at a Barclays industry conference.

Moynihan said that the bank's trading revenue for the third quarter is expected to be "basically flat" compared to the same period last year, which stands in stark contrast to the strong performance of Wall Street's trading business in the first half of this year. Moynihan expects investment banking fee income for the third quarter to be between $1.6 billion and $1.8 billion, while analysts had previously expected nearly $2 billion.

Following Moynihan's remarks, Bank of America's stock price fell as much as 6% intraday on Monday, marking the largest intraday drop since April last year, and finally closed down 5.14%. Other major Wall Street banks such as Goldman Sachs (GS.US) and Morgan Stanley (MS.US) also saw their stock prices come under pressure.

Notably, Moynihan explicitly pointed out that uncertainty in the rate environment is a key factor currently affecting capital markets activity. Only when companies have greater certainty about future financing costs will they be more willing to issue debt. In other words, the current issue is not just the level of interest rates themselves—the sharp volatility in rates is also suppressing corporate financing intentions and banks’ capital market businesses.

Deeper Root Cause: High Inflation Squeezing Bank Net Interest Margins from Both Ends

The reason why Bank of America's earnings warning triggered such a strong market reaction is that it exposes a deeper issue: inflation that continues to exceed expectations is pushing up rates in a way unfavorable to banks.

The source of this round of inflation can be traced back to the U.S.-Iran conflict that erupted about seven months ago. The conflict led to a global energy price shock, with oil prices soaring rapidly, and this soon transmitted to overall prices. The Federal Reserve's preferred inflation index—the Personal Consumption Expenditures Price Index (PCE)—jumped from under 3% in February to over 4% in May, while core PCE, which excludes volatility in food and energy prices, once surged to 3.5%. Although it has since retreated, overall PCE remains above 3.5%, and core PCE is around 3.3%—well above the Fed’s 2% target.

The reason inflation puts pressure on bank stocks lies in how it distorts the rate structure. Fixed-income investors view inflation as a loss of their future purchasing power; when inflation expectations rise, they demand higher returns as compensation. This pushes up long-term rates—the 10-year U.S. Treasury yield exceeded 5% this week—as a direct reflection of increased inflation expectations.

According to Seeking Alpha contributor Jeremy LaKosh, the core of the problem lies in banks’ profit model. Banks borrow funds on the short-term market and lend out in the long-term market, earning the spread between the two—the net interest margin. In a normal rate-hiking cycle, short-term rates rise along with loan rates, and banks' net interest margins typically expand. However, this time is very different.

The U.S. Treasury Department is attempting to suppress long-term rates by “selling short-term debt and buying long-term debt.” Data shows that since the last Fed meeting, the yield on long-dated U.S. Treasuries has increased by about 15 basis points, while the yield on two- to five-year Treasuries has risen by more than 40 basis points. Despite some effect from the Treasury Department's operations, it still needs to issue short-term bonds to raise funds, which further drives up short-term rates.

This means banks’ short-term funding costs are rising rapidly, but the yields on long-term loans are being suppressed by Treasury Department market operations. With borrowing costs rising faster than lending yields, net interest margins are being clearly squeezed, ultimately dragging on bank profitability.

Pressure on Bank Stocks Remains: Rate Hikes Can't Alleviate Inflation Worries, Rate Volatility the Core Variable

The Fed on Wednesday as expected raised rates by 25 basis points to a range of 3.75%—4.00%, the first hike since July 2023, and sent a hawkish signal of possible further hikes this year. But for bank stocks, the key is not the hikes themselves, but rather that investors worry the hikes have not effectively suppressed inflation expectations and, combined with Treasury issuance operations, are instead squeezing net interest margins.

Many market participants believe the current inflation is mainly driven by supply-side factors and that rate hikes may be ineffective. LaKosh suggests this view is theoretically sound, but the key to determining whether current inflation is only temporary depends on whether services inflation will be “ignited.”

At present, most inflationary pressure is still concentrated on the goods side. The problem is that if inflation starts to spill over into services, it may take much stronger rate hikes to regain control of prices. Post-pandemic experience has already shown: once services inflation takes root, the policy cost rises significantly.

Before the Fed acted, some argued for preemptive rate hikes to prevent inflation from becoming entrenched in services and avoid further rate volatility. Now the Fed has chosen to hike and sent a hawkish signal of possible further hikes this year, but this week's market reaction suggests rate hikes themselves have not dispelled inflation worries. Most economists expect the 2% inflation target won't be reached until at least 2028.‌‌

For bank stocks, short-term earnings fluctuations are worthy of attention, but the more important variable is whether the rate environment can stabilize quickly. Moynihan also expressed a similar view: "Rates will eventually stabilize, and I think that will help some trading activity."

From an investment logic perspective, rate hikes are not an unqualified positive for bank earnings. In periods when fundamentals are strong and credit expansion and margin growth happen simultaneously, bank stocks often trend higher; but if the outlook for fundamentals is under pressure, rate hikes could become a “double whammy” for earnings and valuation. The current market reaction shows that investors are repricing banks’ profit prospects in an inflationary environment—and this repricing may not be over yet.