IT was not in the script for bank stocks in the US and western Europe to fall into a bear market. Coming from a low base, as a wave of regulatory fines were put behind them, they were supposed to surf on a steady economic revival, and on higher rates.

And yet banks are back in a bear market. The US KBW Bank index, covering the biggest commercial lenders, is down 18.5pc for this year alone. The FTSE-Eurofirst 300 Banks index has fallen even more precipitately. Even after last Wednesday’s big bounce, it is down 38.17pc from last year’s peak. This has brought a return to valuations so low that they make sense only if the groups’ existence is imperilled. While the KBW index trades at slightly less than 90pc of book value, European banks trade at only 64.5pc. They were trading at book value less than a year ago.

Meanwhile credit default swaps returned to the agenda, as they showed a greater risk of default for Deutsche Bank than at any time during the 2008-09 financial crisis.

A sell-off for banks seems a long way from the worries around China and the oil market that triggered the sell-off for world markets at the beginning of the year. But there is a link: a rise in concern about central banks.

Markets do not believe that the Federal Reserve will follow through with the four rate rises that its governors have forecast for this year. This belief appears to have survived Janet Yellen’s congressional testimony on February 10, even though she declined to express any regret over having raised rates.

Based on the experience in Japan, JPMorgan study suggests rates could drop as low as minus 4.5pc in the eurozone and minus 1.3pc in the US

In the markets the view persists that the tightening that has already happened will intensify deflationary pressures. Hence inflation break-evens — the implicit forecast for inflation over the next decade, derived from the bond market — have fallen to their lowest since 2009.

The worst effect on the banks is manifested through the so-called yield curve — the extra yield available on long-term bonds compared with short-term bonds. Long-dated bond yields have fallen far more sharply than shorter-term interest rates, as markets have given way to deflation fears. Yields on 10-year Treasuries exceed yields on two-year notes by only 104 basis points, less than at any point during the crisis year of 2008. The yield curve is at its flattest in almost nine years.

It is dreadful news for banks, which make their money by lending at high interest rates over the longer term while borrowing at lower rates in the short term. A steeper yield curve, which was what central banks wanted to achieve, was a recipe for boosting banks’ profits and allowing them to rebuild their capital steadily. In fact their profit outlook has sharply worsened.

An extra factor comes from the Bank of Japan’s decision at the end of January to move to negative interest rates on some reserves. This was meant as a signal that it would do whatever it took to weaken the yen. But the yen is stronger than it was before the announcement, and indeed is stronger than it was at any time in 2015.

The message the market appears to have heard is that not only the BoJ but any central bank can keep stimulating the economy by cutting rates further into negative territory. Mainstream research is feeding into this, with the economics team at JPMorgan producing this week a research paper titled ‘Negative policy rates: the bound is lower than you think’.

Based on the experience in Japan, the study suggests rates could drop as low as minus 4.5pc in the eurozone and minus 1.3pc in the US. Banks could not pass on such negative rates to their clients, denting their profit outlook even further.

All of this is damaging because other potential sources of profits have been closed off. US regulators have clamped down on big banks making money through trading on their own accounts. And the Fed’s latest survey of senior loan officers, which alarmed markets by showing that banks were tightening their lending standards, also showed reduced demand for commercial and industrial loans, while demand for other loans had stagnated.

If the US were to slip into recession, as many in the market speculate, this would be bad for banks’ profits.

Finally, another central bank, the Bank of Portugal, injected greater uncertainty last month with a restructuring of Novo Banco’s debt, which many felt discriminated against foreign bondholders. That set off another round of attempts to hedge against such a risk, including buying protection in the credit default swap market — which served to undermine the equity.

Is there an opportunity here? Probably. Banks in the US had done much to repair their balance sheets. The kind of buyers’ strike that has led them to fall to such deep discounts is hard to justify. After such a sharp decline, a short-term rebound is not at all surprising.

But in the longer term the sell-off reflects risks that are real, and difficult to measure. While the direction of central bank policy remains unclear, and while anxiety persists about the US economy, buying bank stocks is a bet on factors that are beyond an investor’s control.

There will be profits to be made from this scare at some point in the future, but there is no harm in waiting for them.

john.authers@ft.com

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