Soaring Fiscal Deficits, Military Parades and Irrelevant Bank Stress Tests

July 7, 2025 | Last week the Trump Administration rolled the Congress, including the House Freedom Caucus, in a very convincing fashion. The big beautiful bill was signed on July 4th and a parade followed, featuring B-2 bombers, marching bands and fireworks on the Mall. Given the implications of the Trump tax legislation for inflation and market volatility, The Institutional Risk Analyst observes, the perfectly scripted and sanitized celebration in Washington could be the high point for Trump II. 

“Nobody cares about the national debt anymore,” reports Punchbowl News, one of our favorite morning reads. “After years of voting against debt-limit increases – and bragging about it – nearly every Republican has now voted for a $5 trillion debt-limit increase. This is a radical change in GOP orthodoxy, and all because Trump didn’t want to have to cut a deal with Democrats. Only Senator Rand Paul (R-KY) and Rep. Thomas Massie (R-KY) refused to go along, and Trump lashed out at them repeatedly.”

Of course, the logic behind a $5 trillion increase in the authorized limit on the federal debt is that this solves a political problem. Whether the markets will accept trillions in new debt thanks to President Trump’s budget and the Congressional response is another matter. In effect, the US is returning to a COVID era “hot” policy combo of fiscal stimulus and, eventually, lower short-term interest rates, that prevailed during the Biden Administration, but with a pro-business, anti-government rhetorical veneer.

As Punchbowl notes, Republicans attacked the Congressional Budget Office estimate that the big beautiful bill adds $3.4 trillion to the national debt by 2034, but that’s actually the low end of estimates. The Cato Institute projects the total addition of new debt will be more than $6 trillion. 

“The increased willingness of the Treasury to fund more of the deficit using bills is likely to lead to a structural rise in inflation and falling longer-term real yields,” opines Simon White at Bloomberg. “The amount of bills outstanding is already elevated and it may soon go higher after Treasury Secretary Scott Bessent indicated he less favors funding at the long-end of the curve.”

As we describe in “Inflated: Money, Debt and the American Dream,” the public market for Treasury debt was created by the Federal Reserve Board in the 1950s and funded in the repurchase market. This fragile construct has been slowly disintegrating since 2008, when many of the nonbank primary dealers were annihilated. This is why we suggested earlier this year that Treasury Secretary Scott Bessent allow investors to buy discount bonds in the market to pay tariffs and taxes (“Should Treasury Accept Debt for Tax Payments?”). 

You can raise the debt ceiling in Washington, but somebody must sell Treasury debt to an investor. This is one reason that Secretary Bessent has suddenly stopped talking about issuing more long-bonds. Now apparently he wants to follow his predecessor, Janet Yellen in issuing T-bills to finance the federal debt.  Issuing mostly T-bills to finance new and existing debt is the last resort before the US will be forced into a default or outright restructuring. But of course, nobody is talking about that this week in Washington.

Right on time to coincide with the latest tax cuts, the Fed’s annual bank stress tests were just released. The analysis focuses almost entirely on credit risk and ignores the key risk facing US banks, namely market risk due to the federal budget deficit and the Fed efforts to keep the Treasury market open. Imagine if the Fed had to tell the public that federal deficits were bad for bank safety and soundness? We haven't had a Fed chairman since Arthur Burns who would speak publicly about the inflationary aspect of federal deficits.

We have taken the DFAST Table 10, “Projected losses by type of loan for 2025: Q1–2027:Q1 under the severely adverse scenario,” which includes 22 banks, and compared it to net losses vs average assets in Q1 2025. Then we added net loss from Q1 2025 from the FFIEC and created a ratio between the actuals and the stressed loss rate, and sorted the group from highest to lowest. We’ve marked the irrelevant banks in blue. All of them could be dropped from the Fed DFAST analysis next year.

As we noted with the previous DFAST tests, the most interesting information provided by the Fed is the stressed loss rate, which tells you how the Fed Supervision & Regulation staff view the bank. The change from the current baseline is dramatic in most cases, but some banks see far larger changes than others, an indirect comment on the bank’s business model. 

Of note, Joshua Franklin at the FT reports that the Fed ignored private equity exposures in the 2025 stress tests, a remarkable confession of incompetence by the Fed staff. But why are some of these banks even in this stress test? There are several banks from Canada and the EU the ought not even be on this list at all, such as BMO, Deutsche Bank, UBS and RBC USA. Call it politics. Why are back-office shops like the Bank of New York (BK), State Street (STT) and Northern Trust (NTRS) in a test that emphasizes credit risk? 

There are several fast-growing lenders that ought to be included in this group such as Synchrony Financial (SYF) and First Citizens (FCNCA). Add KeyCorp (KEY), now the largest player in commercial real estate with the exit of Wells Fargo (WFC), and add Fifth Third (FITB) if you are going to include wholesale lender M&T Bank (MTB).  Right?

The good news is that the banks mostly passed the Fed's absurd stress tests with flying colors. The bad news is that the Trump Administration's growing enthusiasm for issuing T-bills is going to weight upon bank asset returns as financial repression comes back into fashion. Just as banks and the Fed financed the government's cash needs during the Great Depression and World War II, in future the banks are going to be forced to be buyers of T-bills as the Fed inevitably restarts quantitative easing, which has the effect of increasing reserves and bank deposits.

Notice in the chart below that as gross interest income has risen dramatically post-COVID, net interest income has been flat. As the economy slows, loan yields and deposit rates are falling.

Source: FDIC

Here's a delicious thought: What if the FOMC was forced to fold its arms and do nothing in terms of balance sheet expansion in the face of far larger fiscal deficits? Whether or not Chairman Powell or his successor change the federal funds rate target is a matter of indifference. But if the Fed does not rapidly grow the system open market account (SOMA) to soak up some of President Trump's mounting red ink, then inflation will rise significantly, the dollar will test the lows of Trump I and gold will soar.

QE, after all, cushions the immediate impact of fiscal deficits on inflation, but inflates the banking system dollar-for-dollar. Does anyone in the Trump White House get the joke? Somewhere, former Federal Reserve Board Chairman Ben Bernanke is laughing.

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