The Federal Reserve’s balance sheet reduction as part of its tightening monetary policy is viewed as a distinctly negative factor for the US currency. This assessment comes from George Saravelos, Deutsche Bank’s global head of FX research. The expert suggests that if the American regulator, under the leadership of new Chair Kevin Warsh, shifts its focus from raising interest rates to withdrawing liquidity, the dollar could face significant pressure. Currently, the Fed’s balance sheet stands at approximately $6.7 trillion, down from a peak of $9 trillion in 2022.
As a notable example, Saravelos points to the experience of the Bank of Japan. In recent years, the Japanese regulator has conducted quantitative tightening at record speeds, allowing government bonds to mature without reinvestment. However, these measures have not prevented the yen from falling to 40-year lows, as balance sheet reductions without corresponding increases in short-term interest rates cannot strengthen a national currency. Furthermore, the emergence of a bearish steepening of the yield curve offers considerably less support to the dollar than a flattening that accompanies rising rates.
A second issue related to potential balance sheet tightening, according to the analyst, is the inevitable conflict with the US administration, which is interested in keeping long-term yields low. Deutsche Bank expressed skepticism about the effectiveness of balance sheet reduction as an inflation-fighting tool, warning that adopting this strategy instead of raising interest rates would be interpreted by the market as a clear bearish signal for the US dollar index, which is currently hovering around 100.77.