The looming trap for American banks: Why financial stability demands Fed intervention

The American banking sector currently faces an unprecedented level of interest rate risk that threatens the fundamental solvency of traditional lending models. After a decade of suppressed volatility, the rapid transition to a higher-rate environment has left many institutions holding vast portfolios of low-yield, long-duration assets—primarily Treasuries and mortgage-backed securities—that have suffered significant mark-to-market losses. Unlike the liquidity crises of the past, the current systemic fragility is rooted in a duration mismatch where the cost of liabilities (deposits) has adjusted upward far more rapidly than the yield on legacy assets, compressing net interest margins and eroding capital buffers across the industry.

This precarious position is the direct result of a unique "perfect storm" in the debt markets: a prolonged era of ZIRP (Zero Interest Rate Policy) overlapping with an un-inverted yield curve. During the low-rate years, banks were incentivized to "reach for yield" by extending duration. The curve then inverted, and now, as the yield curve moves toward a more "normal" upward slope—not through a drop in short-term rates, but through a "bear steepener" where long-term yields rise—the market value of those long-term holdings is cratering. This transition from an inverted curve to a positive slope is historically where the most acute financial accidents occur, as the "hidden" duration risk in bank portfolios is suddenly forced into the light by market pricing.

Consequently, the Federal Reserve is approaching a pivot point where its dual mandate of price stability and maximum employment may be eclipsed by its implicit third mandate: financial stability. To prevent a systemic de-leveraging event or a wave of technical insolvencies, the Fed will likely be forced to initiate a targeted form of Quantitative Easing (QE) specifically at the long end of the curve. By becoming the "buyer of last resort" for long-dated paper, the Fed can cap long-term yields, effectively engineering a ceiling on duration losses for the banking system. While this may complicate the inflation fight, the alternative—a disorderly collapse of bank balance sheets—is a risk the central bank cannot afford to take.

The recent cooling of the U.S. economy: Tariffs or Fed tightening?

The recent cooling of the U.S. economy has sparked a debate, with some commentators pointing to trade tensions and tariffs as the primary culprits. While it is true that tariffs can disrupt supply chains and raise costs, their impact on an economy the size of the United States is often overstated. Instead of focusing on external factors, a more accurate assessment of the current economic slowdown requires a look at domestic monetary policy. The Federal Reserve, by raising its federal funds rate and keeping it elevated for an extended period, has directly engineered a slowdown in economic activity. This policy tightens financial conditions, making it more expensive for businesses to borrow and invest and for consumers to purchase big-ticket items like homes and cars.

History provides a powerful precedent for this economic dynamic. In the early 1980s, under the leadership of then-Fed Chair Paul Volcker, the central bank aggressively hiked interest rates to combat rampant inflation. The federal funds rate soared to a staggering 20%, a move that successfully crushed inflation but also intentionally triggered a severe recession (see figure below: Fed Funds Effective Rate - Gross Domestic Product). This historical episode serves as a clear example of the Fed's immense power to slow down the economy through monetary policy. The current situation mirrors this playbook, albeit on a less dramatic scale, as the Fed's actions have systematically removed liquidity from the financial system and reduced demand.

To see this cause-and-effect relationship in action, one only needs to look at the data. A review of historical economic trends reveals a strong correlation between the federal funds rate and overall economic growth, as measured by GDP. The periods following sustained rate hikes often coincide with periods of economic contraction or slower growth. The data clearly shows that the real force at play in the current economic environment is not trade policy, but the deliberate and often-overlooked decisions of the central bank. For a brief discussion on this, along with a few other related topics, please refer to the video linked below.

The Fed's long reach: Influencing the 10-year Treasury

The 10-year U.S. Treasury yield serves as a linchpin for numerous borrowing rates across the economy, making it a crucial determinant of both consumer and business spending. Its influence extends to mortgage rates, corporate bond yields, and even the cost of auto loans. When the 10-year yield rises, it generally signals tighter financial conditions, leading to higher borrowing costs and potentially dampening investment and consumption. Conversely, a fall in this benchmark yield can ease financial constraints, encouraging borrowing and stimulating economic activity. This pervasive impact underscores the significance of the 10-year Treasury in shaping the overall economic landscape.

A commonly held belief within financial circles is that the Federal Reserve's monetary policy tools are primarily effective in controlling short-term interest rates, most notably the federal funds rate. The traditional view suggests that while the Fed can directly dictate the cost of overnight borrowing between banks, its influence over longer-term yields, like the 10-year Treasury, is largely indirect, mediated through market expectations of future short-term rates and inflation. This perspective often portrays the long end of the yield curve as being more subject to the ebb and flow of market sentiment and long-run economic forecasts, with the Fed's direct control seen as limited.

However, the Federal Reserve's response to the Global Financial Crisis provides a compelling historical example of its capacity to directly influence 10-year U.S. Treasury yields. In the years following the crisis, the Fed implemented multiple rounds of quantitative easing (QE), involving the large-scale purchase of long-term Treasury bonds and mortgage-backed securities. These actions directly increased demand for these assets, putting downward pressure on their yields, including the 10-year Treasury. For instance, during QE2 (November 2010 - June 2011), the Fed explicitly aimed to lower longer-term interest rates to support the economic recovery (see figure above). The subsequent decline in the 10-year Treasury yield during this period demonstrates the Fed's ability to actively shape the long end of the yield curve through targeted interventions. For a brief discussion on this, along with a few other related topics, please refer to the video linked below.

How much do long Treasuries increase with each 1% decrease in the 10-year Treasury yield?

The figure below shows five values of the TLT exchange-traded fund, which tracks the value of Treasury bonds with maturities of 20 years or more (i.e., long Treasuries), and of the corresponding 10-year Treasury yields. The latter, 10-year Treasury yields, are highly correlated, in a lagged way, with the Federal Funds rate. This rate is set by the Fed.

As you can see from the best fitting line equation, there is an increase of approximately 19 points in the value of the TLT for each 1% decrease in the 10-year Treasury yields. So, if the Federal Funds rate us expected to go down, the gain likely to be obtained by investing in long Treasuries in quite attractive. The video linked below provides a brief discussion on this a few other related issues.

How could the March-June 2020 stock market rally have happened if $1T moved to the sidelines?

Summary

- As the rally in the S&P 500 happened, approximately $1T of money moved to the “sidelines”; that is, into money market funds.

- Of that $1T, about 20% was from retail investors and 80% from institutional investors.

- This is not what we have seen in previous recessions. Normally when money moves to the sidelines the S&P 500 goes down.

- One could argue that the money that is on the sidelines would be coming in to take advantage of pullbacks, as the new money that came in earlier is taken out to fuel consumption. Some of these pullbacks could be severe.

The March-June 2020 rally in the S&P 500

The figure below shows the rally in the S&P 500 during the March-June 2020 period. The index has gone from approximately 2,237 to 3,055; up about 36%.

We used the charting feature of Yahoo Finance (). The slow-moving line is the 52-day moving average.

About $1T moved to the sidelines

As the rally in the S&P 500 happened, approximately $1T of money moved to the “sidelines”; that is, into money market funds. This is illustrated by the figure below, with charts from FRED (). Of that $1T, about 20% was from retail investors and 80% from institutional investors.

The top chart shows the growth in money market funds from retail investors. For example, if an individual investor with an account on E-Trade (i.e., a “retail” investor) sells a stock position, that money typically will go into a sweep account tied to a money market fund. The bottom chart shows the growth in money market funds from institutional investors.

So, both retail and institutional investors moved a lot of money to the sidelines. This is not what we have seen in previous recessions. Normally when money moves to the sidelines the S&P 500 goes down.

Many people would interpret this as money leaving the financial markets, in absolute terms. This is not what happened. For each stock sale there must be a corresponding purchase. If investors on the sidelines are buying, and sellers are moving to the sidelines, there should be no significant change the in the total amount held by money market funds.

If investors are selling to raise cash, and stock prices are going up, there must be “new” money coming into the stock market at a higher rate than the rate at which investors are selling.

The Fed’s balance sheet grew by $2T during the rally

As you can see in the figure below, the Fed’s balance sheet grew by about $2T during the rally. It grew $3T from February. That is partly what fueled the rally.

This new money that has been “created” by the Fed takes some time to make its way into the hands of people who can buy stocks. So, what we are seeing here is the beginning of something interesting; a rather rare occurrence.

What does this mean? The bull case

One could argue that the money that is on the sidelines would be coming in to take advantage of pullbacks, as the new money that came in earlier is taken out to fuel consumption. Some of these pullbacks could be severe, because newcomers may be parking money in stocks as they would with a bank account - with money that they need to pay for recurring expenses.

This should propel the stock market higher after each pullback. The increase in consumption caused by the money coming out of the stock market may give the impression that the economy is recovering by itself. The ensuing optimism would push stocks even higher.

But the impression that the economy is recovering would be a mirage, at least early on. This highly volatile bull market would be largely driven by the liquidity injected by the Fed. The volatility would be triggered by mixed headlines; e.g., consumer confidence is up, but so is the government deficit.

We could see something like the S&P 500 reaching 4,000 amid a wave of bankruptcies! Not all companies will go bankrupt, of course. For each local “Supa Burger” that goes bankrupt, there will be a bit more market share for the local McDonald’s and Burger King competitors.

Active investing may shine brighter than passive (index funds) in this scenario. Active investors have to think about a number of issues, such as how failures in one industry can benefit leaders in another. As a Hertz goes bankrupt, Uber may benefit. (Disclosure: the author owns shares of UBER at the time of this writing; and also of MCD and QSR, for the references above.)

What does this mean? The bear case

It is hard to see a scenario where this new money printed by the Fed, the portion available for stock purchases, will all go to the sidelines due to pessimism. Money market accounts are paying very little, because Treasury yields are so low. Investors are compelled to put the money somewhere. The stock market is one of the only options.

It is not hard to see a scenario where inflation will grow due to an increase in money supply, even as GDP contracts. Inflation is bad for fixed-income investing, making Treasuries even less attractive, but inflation is not necessarily bad for stock investing. At least not while inflation is growing but is still relatively low (e.g., low single digits).

This creates a positive feedback loop for stocks!

However, this is a bad scenario if maintained for too long, which could bring about severe economic strain, and another major drop in the stock market. High inflation would eventually prompt the Fed to increase interest rates, without a robust economy to compensate for that tightening if GDP is contracting.

But this bad scenario may take a few years to materialize.