NEW YORK (Reuters/IFR) - U.S. bank stocks and bonds took a pounding on Monday as recession fears compounded concern about their exposure to the energy sector and expectations that global interest rates are unlikely to rise quickly.

Traders work on the floor of the New York Stock Exchange (NYSE) February 8, 2016. REUTERS/Brendan McDermid

The S&P 500 financial index, already the worst performing sector this year, fell 2.6 percent and now stands more than 20 percent from its July 2015 high, confirming the sector is in the grip of a bear market.

Shares of Morgan Stanley slid 6.9 percent in their largest one-day drop since November 2012, while rival Goldman Sachs fell 4.6 percent. Both stocks closed at their lowest since the spring of 2013.

Meanwhile, bonds issued by U.S. banks extended their decline, with the yield premium demanded by investors to hold these securities, rather than safer U.S. Treasury debt, climbing to the highest in three-and-a-half years, according to Bank of America Merrill Lynch Fixed Income Index data.

“Investors’ attitudes seem to be worsening relative to the likelihood of a global recession. I think that’s what financials are reflecting – that their net interest margins are going to be further compressed under collapsing (sovereign) bond yields,” said Mark Luschini, chief investment strategist at Janney Montgomery Scott in Philadelphia.

Yields on sovereign bonds from so-called safe-haven issuers such as the United States, Germany and Japan have tumbled recently as investors increasingly doubt central banks in these countries will be able to raise interest rates any time soon.

The U.S. Federal Reserve late last year pulled off its first rate increase in nearly a decade, but interest rate futures markets now assign just a 1-in-4 chance of another one this year. And the Bank of Japan last month cut rates into negative territory for some bank reserves.

Monday’s drop in U.S. bank stocks follows concern over stress in the financial sector in Europe, where the cost of insuring the European financial sector’s senior debt against default climbed to its highest level since late 2013.

Credit default swaps on several U.S. banks have followed suit. The cost for a five-year CDS contract on Morgan Stanley debt, for instance, has rocketed by more than 27 percent since last Thursday and now stands at its highest since October 2013, data from Markit shows. Citigroup’s CDS, likewise, is at the highest since June 2013.

LITTLE HELP SEEN COMING SOON

Few catalysts appear to be on the horizon to boost the picture for bank stocks.

“It’s a multitude of factors,” but liquidity is among them, said Chris Wheeler, a U.S. bank analyst at Atlantic Equities in London. “Banks are big, liquid stocks. If you want to get money out of the market, it’s a fairly easy way to get it out.”

The bigger issue for the sector is the health of the U.S. economy, Wheeler said.

“If the U.S. economy is not running on all cylinders, then everybody starts to get very nervous,” he said.

Bank shares have also been hit by worries about their exposure to weakness and debt in the energy sector.

Earnings for the S&P 500 index financial sector are expected to fall slightly this quarter and next, Thomson Reuters data show.

BANK DEBT UNDERPERFORMS

The pessimism around bank profits continues bleeding through credit markets as well. High grade financial sector yield spreads have climbed to an average of 211 basis points over comparable U.S. Treasuries, their highest level since August 2012, according to Bank of America Merrill Lynch data.

The widening is a dramatic turnaround for banks, which strongly outperformed other sectors last year, prompting many investors to name them as one of their top picks for 2016.

“Everything has turned on its head in 2016,” said Bill Scapell, director of fixed income at Cohen & Steers. “The things people got excited about in bank earnings have fallen away.”

“People were excited about the fundamentals of banks improving and the economy getting better, and then you had this big slow down and people worrying about recession.”