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Fed’s Balance Sheet Continues to Shrink

July 13, 2020 By Mircea Vasiu

In a week when three central banks are due to announce their monetary policy decisions (Bank of Japan, Bank of Canada, and the European Central Bank), the driver for the currency market may come from an unexpected source – the Federal Reserve of the United States.

Last week the Fed’s balance sheet shrank for the fourth consecutive week, by almost $90 billion – the most since 2009. The total size of the balance sheet dropped below $7 trillion as emergency loans to primary dealers and foreign central banks matured. The last four weeks’ balance sheet shrinking is the equivalent of a liquidity withdrawal of about $250 billion.

Where Is the Easing?

The Fed was one of the first central banks to respond to the coronavirus pandemic. It lowered the federal funds rate and immediately restarted the quantitative easing program.

The stock market crash in the first half of March was mainly led by investors flying to safety – the USD is perceived as such an asset. As liquidity improved due to the Fed opening swap lines with foreign central banks, the market conditions eased, and the USD eventually weakened. The AUDUSD recovered to 0.7 from 0.55, EURUSD reached 1.14 from 1.07, and others followed a similar path.

Now that the balance sheet keeps shrinking and the Fed does not appear to do anything to stop the process, the question is if the USD weakening trend is over? Moreover, what does it mean from a fundamental perspective – is the market healthy enough and does not need the Fed’s support anymore?

In addition to everything discussed so far, the Fed just brought their repo lending to zero for the first time since the Q3 2019 repo spike. Yet another good sign of stable financial market conditions. What next for the USD?

With less USD liquidity available, the demand for dollars increases significantly. It may not become evident immediately on the market prices, but chasing fewer dollars ultimately leads to currency appreciation.

This week is the most important week for the currency market for the entire summer. After the ECB’s decision on Thursday, investors, and traders will assess the conditions for the rest of the summer, with volatility declining significantly.

If the Fed’s balance sheet continues to shrink in the weeks ahead, while other central banks keep the pedal on further easing, the USD will be back with a vengeance.