Download App

[Deutsche Bank Warns Balance Sheet Reduction Won't Support Dollar; Japan's Experience and Policy Conflicts Add Dual Pressure] ⑴ Deutsche Bank strategist Saravilos warns that if the Federal Reserve shifts its policy focus from raising interest rates to reducing its balance sheet to tighten monetary conditions, the dollar may actually weaken. This judgment contradicts market intuition but is based on empirical logic. ⑵ The Japanese experience provides a clear precedent. Although the Bank of Japan's pace of interest rate hikes was slow, it pushed forward quantitative tightening at a record speed, with a large amount of government bonds not being renewed upon maturity. However, the yen has remained deep in historical lows since 2012, proving that balance sheet reduction itself has extremely limited support for the exchange rate. ⑶ Saravilos believes that for balance sheet reduction to benefit the dollar, it must be accompanied by a substantial rise in short-term yields. Relying solely on the natural maturity of medium- and long-term bonds is insufficient to change the yield curve shape, let alone counteract the structural depreciation pressure brought about by the expansion of the fiscal deficit. ⑷ A more crucial contradiction lies in the fact that the Fed's balance sheet reduction process is likely to directly conflict with the Trump administration's policy goal of lowering long-term yields. The executive branch has clearly expressed its desire to maintain low interest rates, and the tension between central bank independence and fiscal demands may further amplify market uncertainty. (5) Japanese Finance Minister Satsuki Katayama even discussed using domestic savings to support the bond market, highlighting the blurring of the boundaries between the central bank and the treasury after quantitative tightening has become extreme. This signal should also be taken seriously by the Federal Reserve. (6) Overall, the choice of the pace of balance sheet reduction is not only a technical issue, but also involves a complex game of policy coordination and exchange rate feedback. If the Federal Reserve insists on pushing forward quantitative tightening while ignoring the coordination of short-term interest rates, the risk of a weakening dollar in the medium term should not be underestimated. The focus going forward will be on the degree of disagreement within the Federal Reserve regarding the combination of balance sheet reduction and interest rate hikes, and whether the connection between the Treasury's bond issuance pace and the central bank's operations is smooth.