What happened

The stock market is getting hammered on Tuesday. As of 3 p.m. EST, the Dow Jones Industrial Average and S&P 500 are down by 2.7% and 2.6%, respectively.

Bank stocks are getting hit even worse. The financial sector -- going by the Financial Select Sector SPDR ETF (NYSEMKT:XLF) -- is down by more than 3%, and big banks are some of its worst performers. Bank of America (NYSE:BAC) is down by 4.4%, JPMorgan Chase (NYSE:JPM) has dropped by 3.4%, and Wells Fargo (NYSE:WFC) is 3.2% lower. Most other major bank stocks are also underperforming the major averages by a significant margin.

Man looking at financial charts with hands on head

Image source: Getty Images.

So what

The driving force behind the underperformance in bank stocks isn't the market weakness or coronavirus fears themselves. Instead, bank stocks are responding to the fact that benchmark interest rates have taken an unprecedented nosedive. The 10-year Treasury yield has reached new all-time lows several times over the past couple of weeks, and after the Federal Reserve decided to do an emergency rate cut of 50 basis points today, the benchmark Treasury's yield dropped below 1% for the first time ever. (For perspective, it was over 3% as recently as late 2018, and ended 2019 at around 2%.)

10-Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts.

Here's why it matters to bank-stock investors. While all of the big banks make money in a variety of ways, at their core they still rely on interest income to fuel their profits. In other words, the heart of the banking business is borrowing money at a low cost and lending it to customers at a higher cost. The difference between the interest rate a bank pays for its capital and the interest rate charged to borrowers is the bank's interest margin. (For example, if a bank can borrow money at 2% interest and charge 5%, its interest margin is 3%.)

When interest rates fall, that's generally bad for interest margins. After all, banks can't realistically reduce the interest they pay on deposits below zero, but if market interest rates drop, they'll earn less income on things like auto loans and credit cards. Some banks are more susceptible than others -- for example, Bank of America has a higher concentration of non-interest-bearing deposits when compared to the rest of the big banks, which is a major reason it's the worst performer of the three banks I mentioned earlier.

Now what

The true cost of the recent interest-rate plunge on bank earnings, and how long the low rates will persist, are anyone's guess at this point. However, investors can expect that the recent drop in benchmark interest rates will result in lower-than-expected profits from the big U.S. banks -- for the first quarter of 2020 at a bare minimum. If the low rates last longer, we could see bank profits take an even deeper hit. And we're seeing this probability reflected in their stock prices.