April 2025 – The Four Cs of US Government Credit Have Worsened; Why Banks Must Prepare Themselves for the Rising Risk of a Crisis with No Official Sector Put
April 2025 – The Four Cs of US Government Credit Have Worsened; Why Banks Must Prepare Themselves for the Rising Risk of a Crisis with No Official Sector Put
Events are unfolding rapidly. In my March Treasury Talk column, I stated that “my current view is that US stagflation has become more likely than not, with high risks of a US recession to follow because the Fed is likely to wait to act.”
In March I also was concerned that “[o]nce the Fed does cut interest rates; a US capital account crisis is plausible which would imply negative shocks to both the real economy and financial sector coupled with unwelcome new upward pressure on US inflation.” A chart in the March column demonstrated that even prior to the tariffs the US dollar was not playing its usual safe-haven role when the US equity market declined.
Now the risks of a possible financial crisis are coming into view even faster than expected in March. A sharp decline in asset prices and rapid systemic deleveraging began following the Administration’s announcement of tariffs on April 2nd. Mark-to-market sensitive investors like hedge funds faced significant margin calls and deleveraged with spillovers to a broad range of asset classes that had significant unrealized gains (gold, TIPS, G-7 currencies) and could be sold to generate liquidity without realizing losses. This price action has stabilized but been followed by a rapid weakening of the US dollar to a six month low and sharp rise in Treasury yields late last week.
Some analysts suggest that Administration revisions to trade policy or even the promise of fiscal stimulus in H2 2025 will help offset this risky situation. Thus, some large asset managers may still be clinging to positions that made sense when US macroeconomic forecasts were far more optimistic and telling clients to stay the course. They may be hoping for the Administration or Fed to engineer a market comeback later in Q2 that will allow them to recover values and save face.
It would be preferable if they are right about the macrofinancial outlook. But at this juncture I am more worried about the risks of a crisis than in March. Why?
Big picture — it appears that the Administration’s so-called “detox plan” has significantly weakened the four Cs of US government creditworthiness (character, capital, capacity, and collateral). A worsening of the four Cs of US government credit implies higher costs for all borrowers in the US economy. And it is a scenario that very few banks, corporates and households are positioned for.
How have the four Cs of US government creditworthiness worsened?
· CHARACTER: Character is always incredibly important, and it is even more so when one borrows money. Mean-spirited behavior serves no useful purpose in life and even less purpose in statecraft and policymaking. Instead, such behaviors indicate character flaws and weak judgment.
The counterpoint to decades of US trade/current account deficits is that foreigners have accumulated significant investments in the United States. Foreign investors believed in the U.S. The chart below shows the US net international investment position (NIIP) relative to GDP. The NIIP determines whether a country is a net creditor (+) or a net debtor (-). The US net international investment position – the difference between US investment holdings abroad and foreign holdings of US assets – is negative, implying the US is a large net debtor, and totals about -80% of US GDP. Strong private portfolio inflows from abroad were supporting US financial asset valuations through late 2024.
Some moderation late last week and over the weekend of the Administration’s tariff posture unfortunately does not change questions about the character of US leadership and the soundness of US economic policies. Again, some analysts may be inclined to say that tariffs will go away quickly and this too shall pass. That would be nice, but inherently trust is a fragile thing.
Related to trust, last week’s underperformance of long-dated inflation protected Treasuries (TIPS) even as the US dollar declined sharply against most major currencies is suggestive of foreign central bank sales of US Treasuries. Foreign central banks have stable balance sheets and historically have liked holding some USD balances in TIPS because TIPS’ inflation protection affords them some implicit fx hedging. Last week the 30-year TIP rose sharply to a real yield of 2.80%, a level last seen in 2001.
What the Administration learned last week is that the US can withhold access to exporters, but foreign economies also can withhold capital from the US, increasing yields in the US Treasury market and thus reducing the value of all assets in the US economy.
· CAPITAL: US government debt to GDP is high and has the potential to rise sharply if the US economy weakens and US interest rates continue to rise. Some parallels could be drawn to between the April 2nd tariff announcement and President Nixon’s elimination of international convertibility of the US dollar for gold in 1971 which produced significant stagflation. A core difference between the Nixon period and the current situation is the level of US government debt to GDP is significantly higher which makes crisis resolution more complex.
But what about government fiscal stimulus later this year? History shows that fiscal stimulus – both automatic stabilizers and tax cuts — is the single most powerful tool any government has. But my current understanding is that it is not plausible for US tax cuts to make their way through Congress before early August which seems too late given the extent of the damage being wrought by deleveraging and loss of trust. Even more importantly, what investors with stable balance sheets will be willing to step forward to finance a US government budget deficit north of 10% of GDP in H2 2025 when inflation remains a concern, government debt to GDP is high and confidence in economic policy is damaged?
Some policymakers note that removal of US banks’ Treasury holdings from the leverage ratio will help sort the Treasury market situation out if foreign demand wanes. The last time US government debt to GDP was this high was around WWII and roughly 50% of US banking system assets were invested in US Treasuries. Risk-based capital was introduced in the 1950s in part to encourage banks to hold Treasury securities (a zero risk-weight asset). Federal Reserve Regulation Q at that time additionally prohibited banks from paying interest on checking accounts. Ceilings also existed on the interest US banks could pay on other deposit accounts. US banks were heavily invested in Treasuries and bank failures were negligible. In essence, Reg Q permitted the US government to use banks to cheaply and relatively safely fund itself at negative real interest rates — the essence of financial repression. Given interest rate deregulation is not possible to safely use US banks to fund the US government in such a manner though that may not stop some in the banking industry from advocating for it. In sum, the 10-year Treasury term premia which began to rise shortly after the April 2nd tariff announcement may be expected to rise further – which generally also is bad news for US banking sector.
· CAPACITY: At this juncture, the Administration would like the Federal Reserve to cut rates to help reduce the government’s interest expense and narrow the budget deficit ahead of promised H2 2025 tax cuts. However, Fed rate cuts into an environment of above target and rising inflation with fiscal stimulus on the horizon could be poorly received by the Treasury market and instead cause long-term interest rates to rise. Moreover, any Administration attempts to remove sitting FOMC members early could be expected to contribute to a perception of reduced Fed independence and cause a further widening of the 10-year Treasury term premia. This implies challenges for the Administration’s plans to reduce long-dated Treasury yields and term out Treasury debt.
As I alluded to in earlier columns, the Administration seems to view tariffs as part of the H2 2025 tax cut payfor. Thus, tariffs are likely to be more permanent than some may expect. In January, I explained that tariffs can make it seem to some like H2 2025 tax cuts can deliver fiscal stimulus without worsening the budget deficit — the costs are borne by foreign exporters — magic! In reality, it is unlikely that the profit margins of foreign exporters are so high that they will foot the entirety of the tariff bill, particularly with the ~4% US dollar deprecation that has occurred since the April 2nd tariff announcement. This implies that US retailers and consumers will pay a significant share of these new taxes/tariffs, notably slowing US economic growth and potentially offsetting non-tariff tax revenue. The tariffs also can act as a tax on US firms that make use of imported inputs as well.
However, the volume and volatility of the Administration’s tariff announcements may make actual implementation of the tariffs logistically and administratively difficult. Difficulty with tariff implementation risks creating Covid like supply disruptions at US ports and borders. The complexity of tariff implementation also suggests the initial collection of tariff related US government revenue maybe slow initially, but be more keenly felt as a liquidity drain in the weeks and months ahead.
· COLLATERAL. The US government has the power to the tax the US economy – that is its main collateral/asset backing Treasury securities. However, the Administration’s actions have reduced the creditworthiness of the US economy. The tariff announcements have wiped out trillions of dollars in capital and the fall in US equity valuations increases firms’ default probabilities and thus, the borrowing costs of US firms. The ~50 bps rise in the 10-year nominal US Treasury yield last week also reduces other US asset valuations. Additionally, the US economy is known for high levels of innovation – but federal budget cuts to STEM funding risk undermining a key long-term US competitive economic edge.
Stagflation is one of the worst macroeconomic environments for a central bank and economy to face. The Administration is putting the Federal Reserve, commercial banks and the US economy squarely into that situation with tariffs. If the Administration wanted lower interest rates, it could get there with a simple, but effective tightening of fiscal policy without tariffs and that would have lowered inflation and slowed the US economy down and led to Fed rate cuts. Now instead the Administration has put the Fed – and, by extension, commercial banks — in a difficult situation with both pillars of the Fed’s mandate at risk, but market expectations (shown below) for US CPI to move above 3% due to tariffs and supply chain disruptions.
At the same time, whatever US economic forecasts banks are using for their CECL modeling – these forecasts likely are both too optimistic and stale. Bloomberg’s median Q1 US GDP growth forecast has been revised down to 1.1% q/q SAAR – i.e., stall speed — with a weighted average of 0.8%. This compares with a median February Q1 US GDP forecast of 2.2%. Consensus Q2 US GDP growth forecasts still look overly optimistic, likely reflecting expectations of Fed rate cuts or fiscal stimulus that are unlikely to arrive in Q2.
Big picture — four factors imply risks a higher severity crisis may unfold than past crises:
· significantly impaired trust in the credibility of US economic policies;
· reduced international economic policy cooperation;
· limited options for official sector policy support given expectations for a tariff induced near term rise in inflation; and
· the possibility that H2 2025 fiscal stimulus causes long-dated Treasury yields to rise further due to reduced policy credibility.
The US is at risk of an emerging market style crisis. Specifically, capital account crises are when sudden large foreign portfolio capital outflows trigger a sharp decline in the value of the currency/exchange rate and higher domestic interest rates — sometimes also pressuring a country’s banking system. While this may sound far-fetched, the US dollar’s reserve currency status and the stability of the US Treasury market are intimately inter-linked. US banks already have significant unrealized securities losses and commercial real estate values are under pressure. Tariffs will also add unanticipated credit stress to corporate borrowers and the US unemployment rate will begin to rise as well, weakening consumer credit quality.
According to IMF research, historically capital account crises vary in length from 3 to 18 quarters with average and median length at 8 and 7 quarters, respectively. Crisis length is a function of the complexity of the policy and financial issues the country experiencing the crisis faces. Out of the IMF’s sample of 18 capital account crises in emerging economies 8 were triple crises (a triple crisis involves currency, government debt and the banking sector) and 7 were double crises (involved a mix of two of the three factors).
Economic recovery takes longer when the nature of the crisis is more complex. A recovery in economic output took 9 quarters on average for twin crises, and 11 quarters for triple crises, reflecting the greater uncertainty about the policy response and crisis resolution in more complex capital account crisis cases.
The magnitude of exchange rate depreciation increases in relation to crisis scope – with average depreciation in a single or twin crisis is around 25%, while average depreciation in a triple crisis is about 50%. Needless to say, large currency deprecations can also result in significant increases in inflation. In this regard, it is important to monitor market based measures of long-run US inflation expectations.
The change in the fiscal balance/government budget position varies widely across the capital account crisis cases that IMF staff studied. In some cases countries responded with significantly reducing their budget deficits; while in other cases they did not.
The government’s policy response has considerable bearing on the probability of exiting a crisis well. According IMF research, fiscal policy tightening is found to shorten crisis duration. This finding seems to suggest that the confidence building effects of running a smaller budget deficit dominate any contractionary impact on the economy. However, at this point there does not appear to be an intent to propose a US budget that would narrow the budget deficit.
What does this mean for banks?
Banks need to prepare themselves for the rising risk of a financial crisis where US policy may not be perceived by markets as fully credible. Such a scenario implies that the official sector cannot effectively act countercyclically or that typical countercyclical policy actions could actually deepen a crisis.
· The risk of a higher severity crisis in the US is important because some banks and investors may have become conditioned to expect that the official sector can and will always ride to the rescue in stress. Strategies that worked well in past crises – like Covid or even 2008-2009 — need to be reevaluated with the recognition that stagflation and severely reduced economic policy credibility may drastically limit the US official sector response. Banks should recognize that buy the dip fixed income strategies in corporates or agency MBS when spreads widen that may have worked well in prior stress episodes might play out very differently this time. Interest rate volatility also could rise further as opposed to falling.
· Banks should evaluate acquiring some excess term liquidity of at least 2-3 years and for now keeping this liquidity in very short-dated investments. US money markets were fairly benign last week, but the government has yet to begin to drain liquidity from the economy through meaningful tariff collections. Liquidity conditions could change markedly, particularly as April 15th approaches and over coming weeks as rising tariff collections begin to have a broader effect.
· A 6% 10-year Treasury yield in 2025 is a rising tail risk. Banks should consider conducting stress tests with a 6% Treasury yield and stagflationary scenario and developing a potential action plan. Banks particularly need to evaluate EVE risks if US interest rates continue to rise and EVE is not well controlled already.
· Review your bank’s interest rate hedging strategy and if you do not have one, revisit that deliberately but quickly.
· Banks should expect credit events/defaults also will begin to emerge from the decline in asset values and tariff related shocks. It is important to strengthen credit monitoring and workout functions and engage proactively with borrowers to understand how they are being impacted by tariffs and related developments.
· Banks should analyze now likely needs to increase CECL as the US GDP growth forecasts are revised down and the associated implications for your bank’s profitability and capital generation. H2 2025 US economic growth forecasts are still optimistic, reflecting consensus expectations for tax cuts.
I am sorry to Treasury Talk readers for the steady stream of negative outlooks in 2025 in these columns. I do sincerely hope that I am wrong about a rise in US capital account crisis risks. The kindest interpretation I can offer on how we got here is that different Administration officials are trying to pursue too many policy objectives, some of which are internally inconsistent. But trust in the Administration and US markets also has been critically weakened through how economic policies have been communicated and executed. The Administration has made a series of policy missteps which both a higher 10-year Treasury yield and significantly weaker US dollar now reflect.
The theologian Reinhold Niebuhr stated,“no virtuous act is quite as virtuous from the standpoint of our friend or foe as from our own. Therefore, we are saved by the final form of love, which is forgiveness.” Through this lens, it would be good for the Administration to sit down with other countries, consult with economic and financial policy experts and Congress to collaboratively work out an economic and geopolitical strategy in a manner more reflective of the stability, grace, and empathy that we know can and still does exist in America. I wish all Treasury Talk readers a happy Easter week!
