February 2025: US growth likely to weaken; Fed QT to end; but tail risks rising

This month’s Treasury Talk column will:

1. reprise our concern from January’s column that US growth may weaken and could catch many off guard;

2. discuss the expected end in March to the Fed’s use of quantitative tightening which is positive for banking sector liquidity; and

3. assess potential risks of a US triple crisis (currency, debt and banking) which are less sanguine than one might hope.

Shift in risks towards lower US economic growth even as upward inflation risks remain.

 As discussed in my January column, US economic exceptionalism appears poised to end.  Global equity markets seem to recognize this.

The Atlanta Fed GDPNow forecast has decelerated sharply since January, even as the Cleveland Fed’s InflationNow forecast has CPI remaining above target but suggests headline inflation may edge down from its current level of 3% y/y NSA.

In my January column, three channels that could decelerate US growth in 2025 were noted:

1. fiscal tightening through a shrinkage in the federal workforce and related uncertainty;

2. less migration resulting in both weaker US consumption and labor force growth; and

3. rising US economic policy uncertainty weighing on business fixed investment.

But, median economists’ forecasts for US GDP growth were revised up in January vs December, not down.

Consistent with my January weaker growth thesis since inauguration, consumer discretionary and energy stocks have underperformed.  US equity sector performance paints a picture of a market rotation towards less growth sensitive sectors — like consumer staples and health care — as opposed to more cyclically geared sectors.  Watch economists’ updates to US GDP growth forecasts for markdowns in the weeks ahead. 

What does a potential US growth slowdown mean for banks?

First, potential downward revisions in US growth forecasts imply banks will need to downwardly revise their economic scenarios and increase their allowance for credit loss provisions, pointing to risks to US bank earnings in coming quarters.  As noted in January, expectations for US bank equity performance were riding high after the election with lots of “tourists” investing in US banks.

Second, a US growth slowdown could help lower long-term US interest rates.  On a related note, one potential economic aim of the Administration’s jarring Ukraine policy pivot may be to create some near-term disinflation, specifically through reduction of US government spending on the conflict and perhaps also lower global commodity prices if sanctions and conflict recede.  As someone who worked and lived in the region in my younger days, the recent Trump Administration decision to abandon Ukraine to Russia is wrong.  President Putin has repeatedly obtained relationship resets with various US administrations, all of whom thought they “understood” Russia.  Time and time again the US government has underestimated Russia and had to re-learn that President Putin seeks to undermine independent governments in neighboring states.

So the combo of weaker US growth and potential end to the war in Ukraine could provide some disinflation momentum.  However, tariffs, deglobalization and, most problematically, recent evidence of US consumers’ long-run inflation expectations being less anchored (see jump to 3.5% in chart below) suggest that elevated inflation for now remains a key concern for the Federal Reserve and the bond market.

 The release of January PCE data later this week where consensus expectations are for a touch of disinflation will bear watching.

Finally, stagflation risks – while a tail scenario — are rising and are the worst economic scenario for banks.  Stagflation combines credit risk, interest rate risk, and liquidity risk.  Rising stagflation risk may explain why large bank stocks fell after Walmart’s earnings concerns about “uncertainties related to consumer behavior and global economic and geopolitical conditions” last week.

Both US banks and supervisors are ill-prepared to face stagflation.  It has been so long since US banks faced stagflation that virtually no bank has any meaningful historical data for stress loss model estimation.  Supervisory stress scenarios, including the recently released 2025 supervisory stress tests, do not adequately consider this risk.  The ability of the government and central bank to engage in countercyclical policy is one of the core reasons that banking system losses historically have been lower in advanced economies relative to developing.

In sum, the administration repeatedly has spoken about the willingness to “impose hardship” or “pain” – but, just like tariffs, financial markets seem unable to take these things seriously until it is wildly self-evident.  The coming US growth deceleration is likely to see both a repricing of US assets and a weakening of the US dollar.  Hopefully, inflation also moderates.

End of Fed QT at March FOMC will be good for bank liquidity

The recently released January FOMC minutes suggest an end to ongoing Fed quantitative tightening (QT) may be on the horizon at the March FOMC meeting.  Specifically, the January FOMC minutes stated that “various [FOMC] participants noted that it may be appropriate to consider pausing or slowing balance sheet runoff until the resolution of the Treasury debt ceiling.”

The relevance of the Treasury debt ceiling is that during a debt ceiling episode the Treasury draws down its cash balance at the Fed, injecting reserve balances temporarily into banks.  Thus, Treasury debt limit muddies the water on aggregate liquidity conditions in US banks and, by extension, when the Fed should end QT.  Debt limit is expected to be resolved around July/August.  Thus, the resolution of debt limit and the normalization of the Treasury’s cash position this summer could drain US bank liquidity at the Fed and leave banks strained.  Thus, it quite plausible that a March QT pause ultimately becomes a summer end to QT after the resolution of Treasury debt limit.  A third Fed over-tightening of US bank liquidity (recall overtightening #1 repocyalpse in 2019 and #2 SVB in spring 2023) could dampen the Fed’s credibility.

While on the topic of US bank liquidity, it is interesting that Fed discount window lending has been ticking higher almost immediately since the conclusion of the 2024 election.  The level of Fed borrowing still totals only $3 billion, but it has an upward trend since early November.

Reviewing risks of a US triple crisis – less sanguine than one might hope

This semester I am teaching a course on macrofinance – what a wonderfully engaged group of students!  In a recent lecture, I discussed with students key findings from an important IMF paper about banking crises, “Systemic Banking Crises Revisited” by Laeven and Valencia (L&V).  L&V summarize the global history of systemic banking crises since the US transition to a fiat currency system in the early 1970s.  Their focus is on extracting lessons from the global sample of banking crises, but L&V also consider as part of their study instances of currency and sovereign debt crises.  From 1970-2018, L&V identify 151 banking crises, 236 currency crises and 79 sovereign debt crises.  Based on a recent re-read of their work, I find that US crisis risk is less sanguine than one might hope for.

USD crisis – actually check!  — First, L&V define a currency crisis as a depreciation of the currency by 30% or more in the most recent 12 months and an acceleration in the rate of currency deprecation by 10 percentage points or more relative to the year prior.  The current commonly held view of the US dollar is one of strength given the appreciation of the broad US dollar index, DXY.  However, the US dollar’s deprecation relative to gold and bitcoin meets the L&V definition of a currency crisis, arguably reflecting weakening confidence in US fiscal and monetary policy restraint.  What will happen to US dollar sentiment if the dollar begins to weaken notably against other major currencies as growth and interest rate differentials narrow?

Government debt – honey, please don’t scare the 10-year Treasury term premia!

L&V define a sovereign debt crisis as a default or restructuring of sovereign debt.  Inclusion of Greece’s debt structuring and Cyprus’ debt exchange in 2012 and 2013, respectively, in L&V’s crisis database make it evident that advanced economies are not immune to sovereign debt crises.

Since January, the Administration has demonstrated a willingness to undertake dramatic economic policy initiatives.  Unfortunately, the Treasury market does not appear to be off-limits.  Earlier this month, the 10-year Treasury term premium rose following off-hand comments about potentially “fewer Treasuries” until the White House clarified.

Then at the end of last week rumors circulated about a “Mar Largo accord”– specifically, a potential swap of existing marketable Treasuries held in other governments’ fx reserve portfolios for 100-year zero coupon Treasuries in exchange for US military security guarantees.

While such a government debt restructuring would significantly reduce the net present value of the US debt and also lower the US budget deficit, if pursued, such a debt restructuring also could plausibly result in rating agency downgrades of the US government rating to selective default.  Such ratings actions could be expected to increase the term premia on other marketable Treasury securities and also negatively impact the ratings of some systemic US financial institutions and other US domiciled issuers.  Even if a debt swap is not actively pursued, rumors and talk like this is a worrisome trend.  It could result in a risk premium becoming embedded in long-dated US Treasury yields.

In 2016, Europe experienced the sovereign/bank nexus — let’s keep US banks out of the history books!

Significant dollar deprecation that increased inflation or a further rise in the 10-year term premia could increase the risk of a US banking crisis.  L&V note that currency and sovereign debt crises, on average, tend to coincide or follow banking crises.  As the chart below from their paper illustrates, sovereign debt crises frequently result in overlapping crises to the currency and/or banks.

Government debt requires market confidence and trust for it to act as a cornerstone of a well-functioning banking system.  However, it is essential both that government debt be of high credit quality and that banks manage interest rate risk properly.  Otherwise, government debt can easily turn into a source of banking sector instability.  A loss of confidence in US government debt also could threaten US banks because the government provides deposit insurance which acts as a final backstop for banks.  US banks’ and other systemic financial institutions’ credit ratings reflect the US government’s backstop role

What should banks do as US growth may weaken and tail risks rise?

Summing up, banks should look to pick up cheap insurance against rising tail risks wherever possible and continue to be mindful of capital, liquidity and interest rate risk.  My list of items for bank treasurers to be on watch for in 2025 still stands from my January column, but I would look to buy volatility/be long convexity against key risks.  It is essential banks: 1) guard against complacency which has been evident in financial markets since the start of 2025, 2) have a strong risk culture, and 3) recall that sound risk management is doing the right thing/observing risk limits even if bank regulators aren’t looking.