What happened

The stock market was sharply lower Thursday morning, continuing the week's downtrend. As of 9:45 a.m. EDT, the Dow Jones Industrial Average and S&P 500 benchmark indices were lower by 3% and 2.5%, respectively.

The financial sector was getting hit especially hard. All of the largest U.S. banks were down sharply. Bank of America (NYSE:BAC) was the best performing of the big banks, down by 4.3% on the day. Wells Fargo (NYSE:WFC), JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), and U.S. Bancorp (NYSE:USB) were all lower by 5% or more.

Bank sign on exterior of a building.

Image Source: Getty Images.

So what

There are a few big reasons banks are getting clobbered today. For one thing, banks were some of the best-performing stocks in the May stock market rally, so some of the recent declines could be from investors taking profits.

However, most of today's decline is likely due to two things: first, fears that a second wave of coronavirus infections will devastate the U.S. economy, and second, the Federal Reserve's economic projections.

First, as states reopen, we have started to see a rise in COVID-19 cases, particularly in early-opening states. Texas, for example, has seen record numbers of hospitalized COVID-19 patients for three consecutive days. South Carolina -- also one of the first to reopen -- has reported its highest infection numbers of the pandemic over the past week or so. There have been troubling increases even in some states that have been more conservative about reopening, like California.

The point is that the economic fallout from a bad second wave could be devastating for banks. If states are forced to close businesses again, for example, it could cause a spike in loan defaults.

The other reason banks are falling is the dovish outlook the Federal Reserve released yesterday. To be clear, the economic forecast was quite strong, calling for unemployment to fall below double digits by the end of the year and for 5% GDP growth in 2021. The problem is that the FOMC also projects that interest rates will stay near zero until at least the end of 2022. Since the primary function of banks is to loan money and profit from the interest, it's easy to see why a prolonged low-rate environment isn't the best for the banking industry. Plus, the Fed's willingness to be so accommodating with monetary policy might indicate that we're earlier in the economic recovery than we may have thought.

Now what

Bank stocks have been on quite a roller-coaster ride throughout the pandemic. In most cases, when we've seen positive news related to the reopening of the economy or the virus itself, banks have been a top-performing part of the market. Conversely, we've seen banks get disproportionately beaten down when bad news comes out. We're seeing a bit of the latter today, magnified by the Fed's low-rate outlook.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.