The 9% Fed Stress Test: What If the Dollar Regime Breaks?

Scenario assumptions and LBMR interpretation. A 9% rate is about five points above the FOMC median and above any level this century. Using an illustrative Taylor-type rule, i = r* + π + 0.5(π − 2), with a neutral real rate of 0.75% and a closed output gap (LBMR assumptions, not Fed estimates), 8.75–9.25% requires sustained inflation of about 6.0–6.3%, roughly double today’s core PCE and close to the 2022 experience, when CPI peaked at 9.1% in June. The 2022 cycle also started from zero rates. A similar move now would need a different engine: not a one-off energy shock, but an external-adjustment regime.

The Dollar Regime and the US External Balance Sheet

Official data. The second-quarter current-account deficit widened to $246.0bn, 3.0% of GDP, from $212.6bn in the first quarter, and the net international investment position fell to −$22.42 trillion from −$21.27 trillion (BEA, 24 September), roughly two-thirds of GDP on our estimate. The IMF’s COFER data show the dollar at 56.7% of allocated reserves at end-June against 57.2% in March, a move driven mainly by exchange rates. Foreign holdings of Treasuries were $9.25 trillion in July against $9.49 trillion in February; foreign official holdings fell from $4.01 trillion to $3.77 trillion, with Japan down $135bn and China down $76bn (TIC; part of the fall is valuation, as yields rose).

LBMR interpretation. These are five different phenomena, and only some are in the data:

• De-dollarisation of flows: partial and slow; the reserve share has drifted down for years.
• Reserve diversification: visible at the margin in official holdings of Japan and China.
• Reduced marginal Treasury demand: the scenario’s hinge, and testable. In July net foreign purchases of long-term US securities were $40.6bn, but official institutions bought $44.4bn while private investors were net sellers of $3.7bn; after stock-swap adjustments, net foreign sales were $27.9bn (TIC).
• Outright liquidation and a dollar-system crisis: no evidence.

The stock of foreign-owned assets is not the variable. An annualised current-account deficit of about $1 trillion (LBMR calculation) must be financed every year, and what matters is the price at which the last dollar of foreign demand clears. A small shift from price-insensitive official buyers to price-sensitive private ones raises the yield needed to attract them without any liquidation.

From Foreign Capital Demand to Treasury Term Premium

Market pricing. The 10-year Treasury yield closed at 5.28% on 2 October and at 5.31% on 5 October, its highest close of 2026 to that date; the 30-year was 5.61% on 2 October (US Treasury par yield curve). The 10-year breakeven was 2.36% (FRED, 2 October), so the implied 10-year real yield is about 2.9% (LBMR calculation). Term-premium estimates are model-dependent: the Kim–Wright 10-year premium was about 1.0% on 25 September (Federal Reserve Board, via FRED), and the San Francisco Fed’s Christensen–Rudebusch estimate was 1.49% on 5 October against 1.28% at the 16 September FOMC and 1.16% a year earlier, while the zero-coupon 10-year yield rose from 4.24% to 5.31% over the year.

LBMR interpretation. Over the year the selloff is mostly a policy-expectation and real-yield move: on the San Francisco Fed model the term premium explains about three-tenths of the 107bp rise. Since the 16 September FOMC, however, about 70% of the 30bp increase has been term premium, which is the direction the stress scenario requires. It is not yet clearly a foreign-demand or inflation-compensation story. The stress scenario is the case where the term-premium share keeps rising while policy expectations stay flat. Treasury has so far responded on the supply side with buybacks, not coupon cuts: it kept nominal auction sizes unchanged on 5 August and at least doubled long-end buyback limits to $4bn from 9 September through 4 November. The next refunding statement on 4 November is a key signal.

Fiscal Deficits, Protectionism and Imported Inflation

Official data and external forecasts. CBO projects a fiscal 2026 deficit of $1.9 trillion (5.8% of GDP), debt held by the public rising from 101% of GDP to 120% in 2036, and net interest from 3.3% to 4.6% of GDP; its monthly review put the deficit at $2.0 trillion after eleven months. Tariffs are in flux. The Supreme Court struck down the emergency-powers tariffs on 20 February; a temporary 10% Section 122 duty then ran for its 150-day statutory limit and expired on 24 July, when new Section 301 tariffs of 10% or 12.5% on about 60 economies took effect, alongside Section 232 product tariffs and with legal challenges pending. The effective tariff rate measured from customs data was 6.7% in July, which captures only eight days of the new regime, against 7.7% for 2025 (Penn Wharton Budget Model from USITC data; Tax Foundation). FOMC medians put PCE inflation at 3.7% in 2026.

LBMR interpretation. Fiscal and trade policy interact with the external balance. Tariffs reduce imports but also reduce the dollar supply abroad that finances Treasuries; they add to prices if the dollar weakens; and a recession would widen the deficit through automatic stabilisers just as Treasury supply rises. Strategic and defence spending and energy-related fragmentation add to the supply and price pressures, while higher rates raise net interest costs, closing the loop between monetary and fiscal policy.

The Dollar Paradox: Higher Fed Rates and a Weaker USD

Market pricing. At present the usual relationship holds. The dollar index (ICE DXY) rose about 2% in September, closed at 101.93 on 2 October for a third consecutive weekly gain and traded near 102.5 on 5 October, its highest since April 2025 (Investing.com; Trading Economics). One analyst noted that it was tracking 10-year yields more closely than rate expectations (NAB, via Vantage Markets). The 52-week range to 2 October was 95.6 to 102.2.

LBMR interpretation. Higher US rates strengthen the dollar when they signal higher expected real returns and institutional credibility. They weaken it when markets read them as compensation for risk: a larger term premium, fiscal worries or less foreign willingness to fund. Advanced economies have seen this combination before; the UK gilt episode of autumn 2022 is the closest analogue. The distinguishing test is the sign of the dollar–yield correlation and whether the rise in yields comes through real yields and policy expectations or through the term premium. A positive correlation falsifies the scenario; a persistently negative one, with stable policy expectations, would make it plausible.

The Financial Transmission Mechanism

Scenario assumptions. The loop runs: external imbalance → weaker marginal inflows → higher term premium → higher long yields → lower asset valuations → weaker dollar → imported inflation → Fed tightening → recession → fiscal response → renewed Treasury supply and term-premium pressure. Each step is plausible alone; the stress test assumes they reinforce one another. Valuation effects are mechanical: an equity with an implied duration of 25 years (r−g of 4%) falls about 20% for each 100bp rise in r−g, and property valued on cap rates about 17% for a rise from 5% to 6% (illustrative arithmetic, as in our companion note).

LBMR interpretation. The decisive feature is the last stage. In a conventional recession, inflation falls and the Fed eases. In an external-adjustment regime, a weaker dollar and tariffs keep inflation high while recession and fiscal expansion raise Treasury supply. The Fed would face a stagflationary trade-off, and the relationship recession → lower inflation → lower rates could temporarily break down.

Global Spillovers: Europe, China, Japan and Emerging Markets

Europe. The 10-year Bund (3.4–3.6%) and OAT (4.94–4.95%) have already followed global term premia; European duration is not a clean hedge against a dollar-rates shock. A weaker dollar would raise the euro and tighten euro-area conditions while the ECB faces its own energy shock (see our companion notes).

Japan and China. Japan is the largest foreign holder ($1.10 trillion in July) and its own long yields are rising: the 10-year JGB is near 3% and the 30-year was auctioned at 4.08% on 3 September, with the BoJ at 1.25%. Higher domestic yields reduce the incentive to hold foreign duration. China’s holdings were $618bn, down from $694bn in February, consistent with reserve diversification rather than liquidation.

Emerging markets. Effects diverge. A US rate shock with a strong dollar is the classic tightening of dollar liquidity; a rate shock with a weaker dollar raises global risk premia while easing debt-service burdens in dollars. Reserve cushions and commodity exposure will determine dispersion.

Asset-Class Implications

The key portfolio insight is concentration. A portfolio of Treasuries, US equities, US credit and private assets can look diversified while remaining one bet on US rates, US growth, dollar credibility and global liquidity. The table sets out directional transmission in the stress regime; it is a hypothetical framework, not investment advice.

What Would Falsify the Scenario?

• The dollar rising with yields, with a positive correlation that persists.
• Private foreign investors returning as net buyers of long-term Treasuries and official holdings stabilising on the TIC data.
• Breakevens and long-run inflation expectations remaining anchored (10-year breakeven 2.36% today) and core PCE converging toward the FOMC’s 2.5% path.
• A recession that lowers long yields, restoring the normal relationship between slower growth and lower rates.
• A narrower current-account deficit and orderly auctions without larger concessions.

What Indicators Would Make It More Plausible?

• A negative dollar–yield correlation with the term-premium share of the rise increasing while policy expectations are flat.
• Sustained net private foreign selling in TIC data, further official reductions, weak auction tails and a falling indirect bid.
• A current-account deficit above 4% of GDP and a further fall in the net investment position (BEA, next release 18 December).
• Breakevens drifting above roughly 2.75–3%, renewed tariff escalation and larger coupon issuance at the 4 November refunding (thresholds are LBMR judgement).

Conclusion: The 9% Scenario Is About the Dollar, Not the Fed

The 9% number is not the thesis. The regime change is the thesis. The important question is whether the United States could eventually face a simultaneous adjustment in fiscal policy, the external balance, Treasury financing, asset valuations, inflation and the international role of the dollar. If that occurred, the traditional relationship of recession, lower inflation and lower Fed rates could temporarily break down. Current evidence does not point there: the dollar is firm, growth is solid and inflation expectations are anchored. But the stress test earns its place by identifying which indicators would change that judgement, and by showing that a portfolio need not be hurt by a 9% policy rate to be hurt by the regime that could make it conceivable.