January 2025: Kobayashi Maru and risks to banks around 2025 US economic policy inflections
It is typical going into a new year to write about the future. Doubly so when a radical remake of US economic and financial policy is underway with a new administration. In this column, I will: 1) share an analogy that may be helpful for understanding the new administration’s economic policies; 2) suggest that it is plausible that US economic activity will weaken and long-term rates will fall in H1 2025; and 3) highlight some key areas for US bank treasury to be wary of in the months ahead.
Trump 2.0 and Kobayashi Maru economic policies
The incoming Administration has demonstrated a willingness to try to address a core economic problem – specifically, that US fiscal policy is not on a sustainable path. Unlike several prior US administrations of both parties, the incoming administration seems willing to acknowledge that since 2008, the size of the US government debt stock has been permitted to grow too large. A greater focus on addressing this key risk is welcome.
However, I want to use an analogy that will require Treasury Talk readers to know a bit about Star Trek – one of my favorite tv/movie series — specifically, Kobayashi Maru. For non-Trekkies, Kobayashi Maru is a fictional test in Star Trek where Starfleet cadets confront a decision – attempt to rescue another ship, the Kobayashi Maru — endangering one’s own crew — or leave the Kobayashi Maru to destruction at enemy hands. The scenario is no-win; what do you do?
Star Trek’s hero, Captain Kirk, responds to the no-win test by reprogramming the Kobayashi Maru computer simulation so he can win. Effectively, he avoids the hard choice in a no-win scenario. Arguably, the US (and other advanced economies) face a Kobayashi Maru test with regards to an official sector debt spiral which felt costless during globalization and when there were demographic tailwinds. Dealing with an excessive public sector debt stock amid deglobalization and aging demographics is a no-win scenario. The choices when one faces an elevated debt burden typically are high inflation/currency devaluation or an overly large public debt burden eroding economic growth. Neither choice is appealing.
However, it appears that the incoming administration, like Captain Kirk in Star Trek, is trying to change the very nature of the test. Specifically, the economic plan includes:
1) reduction of the US public debt burden through tariffs and taxes on foreign countries.
2) return to greater use of domestic oil and gas to create some disinflation (though this implies an industry willingness to expand output into falling prices perhaps with the carrot of some regulatory relief or other subsidies?);
3) reindustrialization in the US to increase economic growth; and
4) deregulation of US banks to support investment needed for 2 & 3 and fund the Treasury market.
Big picture a lens through which one can interpret this economic policy package is an effort to address an over leveraged official sector (Treasury + loss making Federal Reserve) through extracting income from abroad and stimulating US economic growth — while avoiding the politically fraught topics of tightening fiscal policy domestically, elevated inflation and the generational inequality related to unsustainable Social Security and Medicare benefits. The global fiat money system has created an over-reliance on deficits and debt.
Like other advanced economies and China, the US has an excessive debt burden and aging demographics, but the new administration’s policy approach in a nutshell seems to be to bring output home and increase US GDP through reducing the US current account deficit. Such an approach transfers some costs of economic adjustment related to the US public sector debt burden abroad.
One of the points emphasized in subsequent Star Trek episodes is that Kobayashi Maru/a no-win scenario is a test of one’s character. As the data below show, the cost of such a tariff policy approach falls very heavily on the US’ closest neighbors, Mexico and Canada, and China. Other countries understandably may be expected to not appreciate this tariff and tax approach as they face their own set of debt and demographic challenges.
The counterpoint to decades of US trade/current account deficits is that foreigners have accumulated significant investments in the United States. 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.
While Mexico and Canada are not significant investors in US assets relative to some other countries, even a moderate amount of foreign disinvestment from US assets could stress US economic performance. Specifically, the US economy is highly financialized and higher asset values and the associated wealth effect for older Americans has kept the US economy strong even as many younger and lower income US wage earners have struggled due to inflation.
Foreign disinvestment from US markets also could raise US interest rates and credit spreads, negatively impacting hoped for investment and US economic growth. Money and investing requires trust. Trust is earned over long periods, but discussions about US territorial expansion and raising revenue abroad could erode international investors’ trust in the US. As bankers know from the dynamics of runs, loss of trust/confidence can happen very abruptly. A loss of international trust in the US would imply a higher for longer interest rate scenario. It puts US bank M&A at risk, keeps US bank funding more challenging and also puts greater credit stress on the table.
But near-term it seems plausible that US economic growth will weaken, and this is not adequately priced in.
President Trump recently signaled that he wants lower US and global interest rates. However, consensus US GDP and inflation forecasts presently are not consistent with near term Fed rate cuts. Rather, markets are priced for US inflation to remain elevated.
Short dated TIPS have outperformed, as anticipated in this column in November. Tariffs will be an immediate one-time boost to US CPI. There are significant structural factors like aging demographics, strong demand for non-tradable services, inadequate housing supply, and changing trade patterns which suggest risks to inflation remaining elevated. That said, only structural economic policies can help. Tighter monetary policy is not the correct tool.
The FOMC is expected to pause rate cuts at this meeting. So how could near-term Fed rate cuts plausibly happen? The fiscal and immigration policy pivots that are underway reduce US economic activity and may pave the way for lower US interest rates in H1 2025. Higher economic policy uncertainty may also reduce business fixed investment.
First, with the US public sector debt stock and deficit so large, fiscal policy has been a dominant force. US fiscal policy is withdrawing stimulus, but this hasn’t yet appeared in the economic data. Cuts to federal discretionary spending – plans to shed government personnel, cuts to federal travel, freezing government grants, contractor spending, etc — seem to be moving very quickly in DC. Greater government efficiency over time may be obtained, but near-term these spending cuts also will show up as a strong negative fiscal impulse that weakens the US economy and even supports the eventual discussion of US tax cuts later in the year.
Second, international migration into the US was significant and contributed to aggregate US demand and higher US GDP.
Further, US labor force growth is a key driver of US GDP growth. Virtually all US labor force growth since Covid was driven by growth in foreign labor. The administration’s more restrictive approach to immigration should be expected to slow economic growth and potentially may also raise inflation.
Third, US economic policy uncertainty has risen (yellow) and generally higher uncertainty is unfavorable to business investment (white) which also contributes importantly to US GDP.
In this way, it is possible that the recent shift in US economic policies could decelerate growth and contribute to lower interest rates in a manner not currently priced in in H1 2025. The Biden Treasury did the US little favors by its over-reliance on T-bills to fund the government. The Treasury Department needs to term out the Treasury market over 2025 – this is one of many reasons why the new Administration seeks lower US interest rates.
However, one cannot count out the bond vigilantes with Fed asset purchases/QE sidelined. As noted in September, ahead of the US elections in November fiscal and monetary policy were both easing simultaneously. The US budget deficit widened from 5.4% of GDP in late July to 7% of GDP as the Fed began to ease monetary policy. This policy combo even as US inflation had not yet come fully back to the Fed’s target understandably brought out the bond market vigilantes. The 10-year Treasury yield higher even as the Fed lowered interest rates three times in Q4 and the 10-year term premia rose.
In this way, ongoing Fed quantitative tightening (QT) implies that the FOMC’s ability to influence US financial conditions, specifically longer dated Treasury yields has been weakened. However, a US economic slowdown in H1 could shift the focus of the Fed’s dual mandate towards risks to full employment as opposed to inflation, support resumed Fed easing and an end to QT.
Perhaps this is why the Treasury Department is asking primary dealers in its Q1 2025 Quarterly Refunding Survey questions like – “when do you expect the Federal Reserve to begin open market operations to grow the size of its balance sheet” and “what Treasury security tenors do you expect the Federal Reserve to purchase and why?” The new administration needs to get the Fed’s balance sheet off the sidelines to bring the bond vigilantes back in line and stop 10-year Treasury term premia from normalizing further.
While near term the US will get a negative fiscal impulse as discretionary spending is cut, what is the intended medium-run path for US fiscal policy? It isn’t towards politically unpopular domestic fiscal consolidation and instead favors more tax cuts. It is possible that “creative” approaches to budget scoring may be discussed and even pass Congress – like using the inflated Q4 budget deficit as a baseline as opposed to law. Maybe this approach will fly in DC if the US economy weakens in H1 2025 for the reasons outlined above. However, such approaches also may provoke the bond market vigilantes who could view it as changing the terms of the test, i.e., more Kobayashi Maru style thinking. Again, stopping the bond market vigilantes is why getting shifting the balance of risk in the Fed’s dual mandate away from inflation and towards full employment and getting the Fed off the sidelines could be an actual economic policy aim.
As we start into 2025, here are some suggested areas for bank treasurers to be wary of in the months ahead.
The range of potential US economic and interest rate outcomes is wide. Remain nimble on the US interest rate outlook and expect interest rate volatility. Long-term rates may come down in H1 2025 and then go back up due to structural inflationary pressures. Also, higher interest rates as a result of reduced international investor confidence in the US cannot be ruled out. The held-to-maturity (HTM) classification which constrains hedging tools really should be used thoughtfully and sparingly in this environment. Interest rate shocks can degrade a bank’s liquidity if its buffer is over-invested in longer dated fixed rate securities.
US bank equity is fully priced for significant deregulation and optimistic earnings. A H1 2025 slowdown in US economic growth, upticks in credit losses and interest rate volatility can be expected to catch “tourist” investors in US banks off-guard. This is relevant for banks considering acquisitions, with weak capital or less stable funding.
Fannie and Freddie privatization is on the table. But given elevated government debt levels, the US government can ill afford to socialize the GSEs’ losses again, as happened in 2008. How will the rating agencies, Federal Reserve and bond and agency MBS investors respond to Fannie/Freddie privatization? It is hard to say. FHLB or Farm Credit may be a more conservative choice of agency debentures for a bank’s liquidity buffer.
US municipal bonds have benefited from federal income tax exemptions since 1913. Given the need for some federal budget pay-fors and elevated policy uncertainty, banks be cautious on municipal bond concentrations.
Insured deposits give governments the right to impose (or alleviate) significant regulatory requirements on banks. One area where deregulation is reportedly “gonna happen” relates to the exclusion of US Treasuries from banks’ supplementary leverage ratios. Remember that deregulation doesn’t alleviate risk – a US government bond portfolio duration >3 in this environment is a potential source of bank risk. It is concerning to see a regional US bank that had ALM issues in 2023 not only invest in higher duration securities, but also put these securities in HTM.
The official sector would like US banks to hold more Treasuries, but banks need to mind the risks and not go too far out the curve. 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.
https://www.fdic.gov/about/financial-reports/reports/archives/fdic-ar-1950.pdf
So, continue to be mindful of your bank’s capital, liquidity and interest rate risk — wishing Treasury Talk readers a great start to an eventful 2025!