They expected the economy to cool thereby causing rates to fall. Because what we're going through--rising rates, falling inflation and persistent growth--is literally the first time an economy of note has managed the opposite of stagflation.
The Fed being constrained by the federal deficit (or even interest expenditure) is a different beast. Nobody serious thinks the Fed would lower rates to finance the government thereby causing inflation. If the Fed is lowering rates, the economy is cooling. That's deflationary. If the economy is doing well enough that lowering rates would cause inflation, there is no need to lower rates.
Stagflation is real. But it's never happened in the way this theory describes (deficits --> lower rates --> inflation amidst recession). And there are simple, well-tested reasons to find that causation ridiculous.
> banks will end up with huge holes in their balance sheets
It's a trivial hole to fill: let banks borrow at the discount window against the face instead of market value of their Treasuries. (At a penalty rate, I would add.)
The persistent problems in banking come from credit risk. That's happening in commercial real estate. But not rates.