In yesterday’s article, “Eight of the Last Two,” I admitted something most economists (spoiler alert: I’m not an economist) never do: I’ve seen more recessions in the shadows than the data ever confirmed. False alarms are part of the job when you pay close attention to the quiet signals. Most fade. A few matter.
I received a lot of questions about this in the last 24 hours, and thought it merited a follow-up. As it stands today (Friday, September 5th), it looks almost certain that the Federal Reserve is going to end up cutting rates into rising inflation and record deficits. While there are benefits to this, namely reduced interest payments on the national debt, I fear the move could result in a cycle that hurts the very institutions people assume benefit most: banks.
Rate cuts are supposed to be good news for lenders. Lower funding costs, cheaper credit, more business. But in the wrong environment, they do the opposite. They destabilize balance sheets, shrink margins, and raise solvency risks. What looks like relief in the short run could be the first crack in the next crisis.
Bond Yields and the Balance Sheet Trap
Banks are full of bonds. U.S. Treasuries. Mortgage-backed securities. Corporate debt. All of it is sensitive to interest rates. When yields rise, prices fall. And the market value of those holdings drops with them.
That’s not just an accounting problem. If banks need liquidity—say, depositors pull funds—they’re forced to sell those assets at a loss. That’s exactly what triggered the 2023 turmoil that brought down Silicon Valley Bank and a few of its peers. Their assets weren’t worthless. They were mispriced for the moment. But in banking, “mispriced for the moment” can be fatal.
Now imagine the Fed cuts rates while inflation is still hot. Long-term bond investors demand more compensation for inflation risk. Yields climb even as short-term rates fall. The paradox is brutal: the very policy meant to help banks erodes the value of their biggest holdings.
This isn’t theoretical. In the mid-1970s, we saw rate cuts into an inflationary environment. Long yields rose. Banks suffered. And the pressure didn’t let up until Paul Volcker eventually slammed the brakes with double-digit rates in the early 1980s.
The Dollar’s Slip and Imported Inflation
Next, consider the dollar. Currency markets are a referendum on confidence. If the Fed cuts aggressively while deficits keep ballooning, global investors could decide the U.S. is no longer serious about price stability. That triggers a dollar sell-off.
A weaker dollar makes imports more expensive. Oil, manufactured goods, raw materials—all cost more. That feeds directly into consumer prices. Inflation that might have been tamed by restraint gets reignited by policy error.
For banks, this shows up in two ways:
Costs Rise: Everything from technology to energy becomes pricier, squeezing operating budgets.
Borrowers Strain: Households and businesses pay more for essentials. Disposable income falls. Loan defaults creep up.
There’s a small silver lining for banks with international exposure. A weaker dollar means foreign earnings translate higher when brought home. But that benefit is outweighed by the broader uncertainty dollar weakness signals. Investors shy away from U.S. assets, global funding markets tighten, and liquidity gets harder to secure.
History rhymes here too. In the late 1980s, dollar weakness and inflation expectations forced the Fed into policy whiplash. Cuts gave way to hikes, which hit banks’ net interest margins and triggered a wave of failures in the savings and loan sector.
Inflation, Employment, and the Credit Cycle
Moderate inflation can actually help banks. Higher nominal prices mean higher nominal loan balances and interest income. But when inflation gets unanchored, the story changes.
Rising prices squeeze borrowers. Defaults increase. Businesses cut costs, including labor. Unemployment rises. And suddenly, a wave of non-performing loans floods bank balance sheets—mortgages, credit cards, small business loans.
At first, lower rates reduce banks’ short-term funding costs. Interbank lending is cheaper. Deposits cost less. Margins expand. But if inflation keeps climbing, the Fed has to reverse course. Higher rates return, funding costs rise again, and loan losses pile up. That’s the cycle leaders should fear: a short-term boost followed by long-term pain.
We’ve seen versions of this before. The 1994 “bond massacre” wasn’t caused by inflation—it was caused by the Fed tightening faster than markets expected. Banks and hedge funds alike lost billions as bond yields spiked. Imagine a similar shock today, only triggered by inflation refusing to die.
Solvency Is About Psychology
Here’s where the risks turn systemic. Solvency isn’t just math. It’s psychology.
On paper, many banks might survive higher yields, weaker dollars, and rising defaults. But once depositors start doubting, math doesn’t matter. The perception of risk becomes reality.
That’s what happened in 2008. That’s what happened in 2023. And that’s what could happen again if rate cuts create the impression of policy recklessness. Regional and mid-sized banks with concentrated portfolios or heavy commercial real estate exposure are the most vulnerable.
Larger institutions may hold up better, thanks to diversified portfolios and direct Fed support. But even they aren’t immune to confidence crises. In every major financial disruption, the dominoes start small before reaching the giants.
Why This Matters for Leaders
If you run a bank, the message is obvious: don’t mistake easy money for easy times. Stress-test for the scenario where rate cuts don’t calm markets, but destabilize them. Hold liquidity buffers. Diversify your exposures. Assume that policy error is always a possibility.
If you run a business, the message is similar: be cautious of overextending just because rates fall. Lower borrowing costs can be a trap if they’re masking deeper instability. What looks like a cheap loan today could be an anchor tomorrow if inflation forces another round of hikes.
For leaders everywhere, the real takeaway is posture. This isn’t about panic. It’s about positioning. Build strength in your systems, your teams, and your strategies before the storm arrives. Because when confidence cracks, it’s too late to adjust.
Looking Ahead
Markets love to believe in straight lines. Rates fall, banks lend, growth resumes. But history rarely plays so cleanly. When cuts come at the wrong moment, the line bends back on itself. Inflation worsens. Yields rise. Banks strain. The economy stalls.
That doesn’t mean collapse is guaranteed. It means leaders should prepare, not assume. Recognize that rate cuts are not a gift in every environment. Sometimes they’re a warning.
Yesterday I wrote about the danger of false signals. The trick was to see which shadows mattered. This is one of them.
A Final Thought
Lower rates in the face of inflation and deficits are not a cure. They’re a gamble. One that risks weakening the very foundations of banking stability—asset values, funding costs, credit quality, and solvency.
Banks that prepare can survive it. Banks that assume “cuts mean comfort” may not.
The Fed might get it right. Markets might stabilize. But leadership isn’t about betting on maybes. It’s about building resilience for when the easy story falls apart.
And if history has taught us anything, it’s that the easy story rarely lasts for long.