Deutsche Bank Says Fed Balance Sheet Cuts Could Weaken US Dollar Instead of Boosting It

Deutsche Bank believes the U.S. dollar could come under pressure if the Federal Reserve chooses to tighten monetary policy primarily by shrinking its balance sheet rather than raising interest rates.

The view comes as the Fed adopts a more hawkish stance under Chair Kevin Warsh. Last month, at least half of the 18 Federal Open Market Committee (FOMC) members projected at least one interest rate increase this year, while Warsh emphasized the central bank's commitment to restoring price stability. He has also launched a broad review of the Fed's monetary policy framework.

In addition to raising rates, the Federal Reserve can tighten financial conditions by reducing the money supply through quantitative tightening (QT). The Fed's balance sheet has already declined to roughly $6.7 trillion from its pandemic-era peak of about $9 trillion in 2022.

George Saravelos, Deutsche Bank's global head of FX research, pointed to the Bank of Japan (BoJ) as an example of how aggressive balance sheet reduction may not necessarily strengthen a country's currency.

According to Saravelos, Japan has withdrawn liquidity at one of the fastest rates among G10 economies by allowing large volumes of Japanese government bonds (JGBs) to mature without replacement. Despite this aggressive QT, the Japanese yen has remained weak, recently falling to a four-decade low against the U.S. dollar.

He argued that balance sheet tightening alone is unlikely to support a currency unless it is accompanied by higher short-term interest rates. Historical evidence also suggests that a steepening U.S. yield curve driven by balance sheet reductions is less supportive for the dollar than policy tightening achieved through higher front-end yields.

Saravelos also warned that a faster reduction in the Fed's Treasury holdings could create friction with the Trump administration, which has expressed a preference for keeping long-term borrowing costs low.

While some market participants argue the Fed's balance sheet remains oversized, Deutsche Bank said its holdings of U.S. Treasuries are not unusually high by historical standards. The bank questioned whether additional balance sheet reductions would effectively curb inflation and concluded that any shift away from interest rate hikes toward balance sheet tightening would likely be a bearish signal for the U.S. dollar.

The U.S. Dollar Index (DXY), which measures the greenback against six major currencies, last closed at 100.77.