Reducing the balance sheet is not a cure-all, Deutsche Bank warns of Japan’s cautionary tale

⑴ Deutsche Bank strategists have voiced doubts regarding Federal Reserve Chairman Walsh's approach to balance sheet reduction, arguing that simply relying on bond offloading may not tighten financial conditions as expected and could potentially repeat Japan's experience.⑵ The Bank of Japan once implemented more aggressive quantitative tightening by allowing large amounts of government bonds to mature without renewal, marking the fastest pace of balance sheet reduction among G10 economies. However, the yen has experienced a persistent depreciation trend since 2012, demonstrating that balance sheet reduction alone does not necessarily support the value of the local currency.⑶ George Saravelos, Deutsche Bank's Head of FX Research, pointed out that for balance sheet downsizing to generate positive effects for a currency, it must be accompanied by a substantial rise in short-term government bond yields; if only mid- and long-term bonds mature naturally, the effect will be significantly diminished.⑷ A greater contradiction lies in the likelihood that Walsh’s commitment to scaling back the balance sheet could directly conflict with the Trump administration’s preference for maintaining low interest rates. With the fiscal deficit consistently above 6% of GDP, artificially suppressing interest rates to control interest spending might become an inevitable policy choice—an approach that is at odds with Walsh’s tightening agenda.⑸ Saravelos also noted that the Federal Reserve’s current holdings of US Treasuries are not excessively large, and the actual effectiveness of balance sheet reduction in containing inflation could be overestimated. If Walsh insists on making this the main policy line, Deutsche Bank views it as a structural bearish signal for the US dollar.⑹ Japan’s experience suggests that excessive pace in balance sheet reduction could instead exacerbate economic vulnerabilities, and the ultimate direction of the exchange rate depends on the shape of the interest rate curve and the coordination of fiscal policy, rather than simplistic changes in asset size. Whether Walsh’s plan for balance sheet reduction can gain cooperation from the executive branch remains unknown.⑺ Going forward, the market will focus on the extent of internal disagreement within the Federal Reserve over the pace of the reduction, as well as whether the coordination between the Treasury’s debt issuance plans and central bank operations is smooth. These factors will jointly determine the underlying logic of the US dollar’s medium-term trajectory.