What does the Fed's shrinking of its balance sheet mean and what impact does it have on the foreign exchange market?

  The so-called shrinking of the balance sheet refers to reducing the size of the balance sheet, that is, reducing assets and liabilities at the same time. The reduction of assets is mainly to reduce the purchase of bonds and MBS, while the reduction of liabilities is mainly to recover the dollar. This article focuses on what it means to shrink the Fed's balance sheet and the impact of the Fed's shrinking on foreign exchange.

​​

  What does the Fed's shrinking balance sheet mean?

​​

  The Fed’s shrinking of the balance sheet refers to the reduction of the balance sheet of the United States. In other words, it is an operation carried out in the United States to reduce the balance sheet, that is, the Fed sells its holdings of treasury bonds, MBS and other assets, and recovers the assets issued within a certain period of time. Currency, the consequence of this operation is the reduction of dollars in the international market and the shortage of market funds.

​​

  The so-called "shrinking of the balance sheet" refers to the reduction of the size of the Fed's own balance sheet. It is the act of the central bank to reduce the size of its balance sheet. The Fed can directly recover the base currency by directly selling the bonds it holds or stopping the reinvestment of maturing bonds, which is equivalent to raising interest rates in disguise and is a more severe tightening policy. The balance sheet means that when the central bank needs to print banknotes, it needs asset collateral such as bonds, gold, etc. This collateral is the "assets" of the central bank. Every time the central bank prints a bill, there is an additional liability, and the Fed's liability is the dollar. According to assets = liabilities, this is the balance sheet.

​​

  To put it simply, "shrinking the balance sheet" means withdrawing currency from the economy, reducing the currency and increasing the value of the corresponding currency. It can be described as a reverse operation of "QE", so the Fed's shrinking of its balance sheet is equivalent to a disguised appreciation of the US dollar.

​​

  Reasons for the Fed to shrink its balance sheet:

​​

  1. The recovery of the U.S. economy is basically completed, but the easing policy during the economic contraction period will soon push up the asset bubble, which is unfavorable to the domestic economic level.

​​

  2. A shrinking monetary policy should leave room for the next recession. It should be noted that the formulation of monetary policy needs to match the economic cycle, and relevant economic policies should match the monetary cycle.

​​

  3. This operation will help stimulate the growth of bank credit.

​​

  4. The Fed's shrinking of its balance sheet can be simply understood as a small interest rate hike, which can prevent the yield curve from continuing to flatten. If the Fed continues to raise interest rates, it may lead to a flatter yield curve.

​​

  5. It is beneficial to reduce the risk of assets related to the Fed.

​​

  What impact does the Fed's shrinking balance sheet have on the foreign exchange market?

​​

  Balance sheet shrinkage refers to the act of the central bank to reduce the size of its balance sheet. The Fed can directly recover the base currency by directly selling the bonds it holds or stopping the reinvestment of maturing bonds. Compared with raising interest rates, it is a more severe tightening policy. That is to say, the effect of raising interest rates is to make the US dollar more expensive, while the effect of shrinking the balance sheet is to make the US dollar less, and the tightening monetary policy will be amplified several times.

​​

  The shrinking of the balance sheet has a stronger impact on the currency contraction and has a greater impact on the funds in the market. The shrinking of the balance sheet is equivalent to the central executive order, which directly draws wages from the bottom line and directly withdraws the money from the market. The flow of funds in the market becomes a problem, and the result will promote Private interest rates rose sharply. And shrinking the balance sheet is more direct than raising interest rates. Because of the interest rate hike, capital does not necessarily return to China immediately. The money earned from overseas speculation is much stronger than interest income in China, or it is unwilling to cut the meat if it loses money from overseas speculation.

​​

  In short, the market impact of the Fed's shrinking balance sheet is still very complicated. The effect of supporting the US dollar and the suppression of non-US currencies are in a complex and changeable impact. For foreign exchange investors, they should pay more attention to the trend of the US dollar exchange rate, and adjust their investment strategies in time to make foreign exchange investment more favorable.