The first half of 2025 has been eventful, and the second half promises to be equally dynamic. Two significant policy developments are poised to profoundly influence liquidity flows in the U.S. economy. The first is a set of proposed capital rule changes for U.S. banks, designed to enhance their capacity to hold Treasury bonds. The second is a fiscal policy mix of high import tariffs and a tax-cutting budget bill, which will likely alter deficit trajectories over the short, medium, and long terms, as discussed below.
On Wednesday, June 25, 2025, the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC) proposed easing capital requirements for the largest U.S. banks. The plan aims to free approximately $220 billion in capital held within bank subsidiaries, enabling institutions to allocate more resources to activities like broker-dealing, particularly in warehousing U.S. Treasury bonds. This move seeks to bolster resilience in Treasury markets, reducing the likelihood of dysfunction and the need for Federal Reserve intervention during future stress events, as emphasized by Fed Vice Chair for Supervision Michelle Bowman.
The proposal, subject to a 60-day consultation period, is less aggressive than earlier expectations of excluding Treasuries from the supplementary leverage ratio (SLR) calculation—a measure temporarily adopted during the COVID-19 pandemic. Nonetheless, it marks the first concrete step toward bank deregulation since President Trump took office in January 2025. The Fed is also set to host a conference on July 22 to discuss leverage ratio designs, with further loosening of capital rules anticipated.
These changes address a critical need: stabilizing the Treasury market amid declining foreign investor interest. I have previously argued that one of Trump’s objectives has been to weaken the U.S. dollar (Cleanest Dirty Shirt, Trump 2.0, Trump’s Economic Goals). He has succeeded in this endeavor, with the dollar down 11% since the start of 2025 and one of the worst performing six months for the greenback in history. Trump has spooked foreign investors with his ‘foreigners will pay’ stance and statements about interest rates needing to be at 1% which is reminiscent of Turkey’s President Erdogan (Don’t be a Turkey). By enabling banks to hold more Treasuries, regulators aim to fill this gap, ensuring liquidity in government debt markets. This could support the dollar and potentially trigger a short-term mini rally. However, easing capital rules may expand bank balance sheets, increasing the U.S. money supply and potentially pressuring the dollar’s value over the long-term, which could prompt foreign investors to further liquidate U.S. assets.
The proposed capital rule changes are not expected to take effect until at least August 25, 2025, following the public comment period. In the interim, the Treasury Department faces heightened issuance demands, particularly if Trump’s budget bill, which includes a $5 trillion debt ceiling increase, passes before July 4, 2025 (as appears likely). This could strain liquidity, as the Treasury seeks to replenish its General Account, which it has been using to pay bills and now faces a $400 billion shortfall. This may lead to a short-term liquidity squeeze, potentially negatively affecting asset prices. However, if equity markets focus on the medium- and long-term fiscal boost, consumer wealth effects could sustain economic momentum, provided bond yields do not spike excessively.
In the medium term (2026), the budget bill’s impact will peak, sharply widening deficits, while tariffs provide a stable revenue stream. Wharton projections indicate that the bill’s deficit effects will vary significantly year to year, with 2026 marking the most dramatic expansion. U.S. equities, already at record highs, are poised to climb further if investors focus on this fiscal stimulus and capital flight is avoided. The prospect of increased fiscal spending is already fueling investor optimism.
Over the long term (through 2034), the budget bill’s fiscal costs are expected to significantly outweigh the benefits of tariffs. According to the Wharton budget model, the House-passed version of the bill would increase primary deficits by $4.6 trillion through 2034. In contrast, tariffs, if maintained at current rates, are projected to generate $1.8 trillion in revenue, per Yale Budget Lab estimates. This results in a net increase of $2.8 trillion ($4.6 trillion minus $1.8 trillion) to the Congressional Budget Office’s January 2025 projection of $8 trillion in cumulative primary deficits, eliminating any anticipated deficit contraction as a share of GDP.
Persistent deficits, rising bond yields, and growing debt will also inflate the government’s interest bill, further expanding total deficits. This fiscal expansion is likely to lift growth and inflation expectations, pushing bond yields higher while supporting U.S. equities, as corporate earnings benefit. However, the risk of foreign capital flight—reminiscent of the UK’s 2022 budget crisis under Liz Truss—remains a significant concern.
The market’s reaction to the budget is critical. If bonds and equities hold steady, the U.S. could avoid a short-term contraction and anticipate a boost in 2026. Conversely, if markets respond poorly, the economy may struggle to weather the short-term liquidity drag.
