The Massive Rise In The Fed's Balance Sheet Will Not Be Enough To Kill The U.S. Dollar

Summary

• The Fed's balance sheet could reach $12 trillion by the end of 2021, more than 50 percent of the country's GDP.
• On the other hand, it seems that the ECB has reached its political limits concerning QE.
• We do not think that the central bank balance sheet differential will matter in the near to medium term.
• The underperformance of most economies relative to the US will drive the USD higher.

In the past few weeks, some investors have been sharing a few popular charts on the FX markets that overlay the main exchange rates with the yearly change in the central banks’ balance sheets differentials. Historically, we saw in our previous FX articles that two of the most important drivers in the FX market are the real GDP growth differential and the real interest rate differential. However, the titanic liquidity injections from the Fed since the start of the COVID-19 crisis has convinced some participants that the weakening USD scenario is about to materialize in the near to medium term. Figure 1 shows that the Fed’s balance sheet has grown considerably in the past two months, up nearly $3 trillion to a historical high of $6.7 trillion, and is expected to reach $8-9 trillion by the end of the year (40-45 percent of the US GDP). Figure 1 shows the general projections from consensus; the Fed balance sheet could increase up to $12 trillion by the end of 2021. Will it be enough to weaken the US dollar?

Figure 1

Source: Eikon Reuters

The persistent strength of the US dollar in the past 30 months has surprised many investors who have been speculating on a weaker currency on the back of a sharp rise in twin deficits. USD trends have historically lasted for a period of 8 years, and the current rally officially started somewhere in 2012 (depending on the measure of the USD index we use, broad or narrow index), implying that a mean reversion is about to occur.

Figure 2 shows two powerful charts of the EURUSD and USDJPY exchange rates overlaid with the central banks’ (CBs) balance sheet differentials. It is very tempting to conclude that the two main currencies - euro and Japanese yen - are about to experience a tremendous period of appreciation against the greenback in the coming 6-12 months. In addition, we saw that Germany’s constitutional court has recently threatened to block the purchase of German bonds under the ECB long-running stimulus scheme within the next three months unless the ECB can justify its actions and meet the court’s objections. Even though this was first a surprise for market participants, we knew that the ECB was approaching its political limits concerning QE and that EZ policymakers will not be able to expand the CB balance sheet to the levels of the BoJ’s one (over 100% of GDP). Hence, some investors have concluded that the CBs' balance sheet differential between the Fed and the ECB will constantly grow in the coming 18 months, implying a significantly higher EURUSD exchange rate (Figure 2, right frame).

The relationship is even more striking in Japan, where the two time series have been strongly co-moving together in the past cycle (Figure 2, left frame), and the annual change in the CBs' balance sheet differential has increased to a historical high of 63.5% in recent weeks, clearly suggesting a USDJPY exchange rate below 100.

Figure 2

Source: Eikon Reuters

However, we do not think that the CBs' balance sheet differential will matter in the medium term, and that the USD is set to remain strong in the coming months. First of all, it is important to know that the Fed is also considered as the central bank of the world, and that a vast majority of the liquidity injections and implementation of USD swap lines was beneficial for non-US economies and non-US asset prices. Even though the relationship appears strong prior to COVID-19, the CBs' balance sheet differential may become irrelevant in periods of crisis such as this one. Secondly, we think that investors will start to closely look at the fundamentals as the primary driver of currencies once the economies reopen. We definitely think that the elevated period of uncertainty post lockdown, in addition to the travel restrictions, will impact the Euro area and Japan more heavily than the US; hence, we expect the real GDP growth differential to weigh on the euro and yen in the medium term.

We expect the bearish momentum on EURUSD to continue in the coming months; Figure 3 (left frame) shows that the pair is currently flirting with an important upward trending support line that is about to fold this time as the USD gets stronger. Any positive bounce on the pair should be considered as a good opportunity to short it again; the next support level stands at 1.0340, which corresponds to the early January 2017 lows.

The Japanese yen should also continue to weaken as volatility eases in the near term; however, we would keep tight stops on our JPY crosses trade ideas, as the yen is strongly sensitive to a sudden rise in uncertainty. Figure 3 (right frame) shows the strong positive responses from the yen (FXY) when volatility spiked during the Q4 2018 and Q1 2020 selloffs.

Figure 3

Source: Eikon Reuters

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in EURUSD over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[netbluesky]

Yup !

[Robin Heiderscheit]

Brief and high signal to noise. Great piece thanks.

Although I generally agree with the outlook I think bearish momentum in EURGLD will be even stronger than EURUSD.