Chuangcai’s Interpretation: The Fed’s Future Policy Direction Still Holds Uncertainty—A Brief Analysis of “Interest Rate Cuts, Balance Sheet Reduction, and a Stable U.S. Dollar”

[Key Insight] Previously, U.S. President Trump stated that he was not concerned about the depreciation of the U.S. dollar, prompting noticeable weakening in U.S. stocks, bonds, and the currency itself. Market expectations for a weaker dollar intensified, causing gold prices to rise rapidly. Later, Bessenet reaffirmed the strategy of maintaining a strong dollar to stabilize market expectations, while also announcing the nomination for the next Fed chair. As a result, the market briefly entered “Wash” trading—characterized by a preference for “rate cuts plus balance sheet reduction” and a strong dollar. Consequently, the U.S. dollar index rebounded from its bottom, while gold prices experienced a sharp decline.

We believe that, given the current U.S. economic situation characterized by the risk of “stagflation” and the continued weakening of the U.S. dollar in the prior period, this nomination could, in the short term, improve market expectations regarding the creditworthiness of the U.S. dollar—specifically, that is... In the short term, by introducing the concept of balance sheet reduction, the market is encouraged to stabilize the U.S. dollar and U.S. dollar-denominated assets through anticipatory trading. 。

In the future, it will be crucial to closely monitor whether the U.S. dollar index can stabilize under the Fed’s new policy guidance, whether market preference for U.S. dollar assets increases to some extent, and whether this can bolster market expectations of a soft landing for the U.S. economy.

Overall, the global trend toward de-dollarization remains unchanged. As U.S. dollar credibility continues to erode and fiscal sustainability issues stemming from U.S. Treasury bonds persist, we expect the U.S. dollar index to remain relatively low in the medium to long term throughout Trump’s term in office. We anticipate that the Federal Reserve will continue to keep the door open for further interest-rate cuts. Under Trump’s strategy of a weaker U.S. dollar, the overall upward trend in gold prices is likely to persist for now. In the future, balance-sheet reduction may be employed as a non-sustainable tactical measure, and the actual probability of implementing such a reduction is relatively low.

At the same time, we should also pay close attention to the final nomination of the next Fed chair. Should there be any changes, market trading dynamics and asset prices could undergo significant shifts again.

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First, “interest-rate cuts + balance-sheet reduction” will stabilize market expectations in the short term.

  Recently, Warsh nominated the next chairman of the Federal Reserve, and his policy stance points toward “interest-rate cuts plus balance-sheet reduction.” There is considerable debate and uncertainty in the market regarding whether these two policies can be implemented simultaneously or how effective they will be.

First, we believe that the two policies in the future will have different target objectives:

-  Interest rate cut: Primarily, these are “price-based tools” designed to address current economic challenges—such as slowing growth and rising unemployment risks—aiming to lower short-term financing costs and boost aggregate demand. When the economy faces recession risks or the labor market deteriorates, lowering interest rates can stimulate investment and consumption, thereby stabilizing economic growth and employment. This is an effective response to such challenges. Periodic The key tool for the problem;

-  Balance sheet reduction: The “quantitative tools” primarily address the lingering issues from the previous round of easing, aiming to maintain the financial system’s health over the long term, create room for future policy adjustments, and help curb inflation. Balance sheet reduction—by shrinking the massive balance sheet—focuses on... Financial System Structure and Long-Term Inflation Expectations 。

Second, based on the U.S.’s past performance during economic cycles, the market perceives a risk of “stagflation.” It is precisely under these conditions that proposing this policy direction becomes somewhat reasonable.

In the earlier phase, as the Federal Reserve sought to tackle high inflation, it embarked on a rate-hiking cycle accompanied by rapid balance-sheet reduction. Now, although inflation has begun to ease from its peak, economic growth has noticeably slowed down, and indicators such as the unemployment rate have also risen significantly, leaving the economy in a state of “stagflation.” Against this backdrop, the Federal Reserve has started shifting toward interest-rate cuts. However, given the rapid decline in the U.S. dollar index, the need to stabilize market expectations has quickly intensified—and Wash’s nomination happens to be well-suited to achieving precisely that effect.

First, we will continue to keep the door open for interest-rate cuts, sending a clear signal of stability to the current market, addressing the risks of economic downturn, and preventing further deterioration in the job market. At the same time, we are also signaling the possibility of balance-sheet reduction, demonstrating that our long-term commitment to fighting inflation remains unwavering and that monetary policy has not shifted course, thereby fostering expectations of a soft landing for the economy.

II. There are still uncertainties regarding the implementation of medium- and long-term policies.

First, in fact, under the Federal Reserve’s monetary policy cycle over the past two years, the combination of interest-rate cuts and balance-sheet reduction has already begun to be implemented. The Federal Reserve’s balance sheet shrank from $9 trillion to $6.5 trillion, and interest rates fell from a high of 5% to 3.5%. It wasn’t until the FOMC meeting at the end of 2025 that Powell announced a temporary pause in balance-sheet reduction, citing concerns about liquidity in financial markets.

Looking back at 2019, after concluding the previous round of interest-rate hikes, the Federal Reserve initiated “preventive rate cuts” in July 2019 while continuing to gradually reduce its balance sheet. It wasn't until September, when financial markets experienced a “cash crunch” (with repurchase market rates soaring), that the Fed was compelled to end its balance-sheet reduction ahead of schedule and began re-expanding its balance sheet starting in October. Therefore, it is believed... Financial market liquidity is one of the preconditions for implementing this policy mix.

Based on the experience from the last interest-rate cut, after the rate cut triggered a depreciation of the U.S. dollar and an outflow of U.S. dollars, market liquidity temporarily became insufficient. Currently, financial market liquidity data remain at relatively low levels seen over the past five years, which poses a constraint on balance-sheet reduction. Breaking down the liquidity structure, the primary reason is that the balance in the Treasury’s general account will gradually replenish and stabilize by 2025, reflecting the earlier period of tight government funding.

Therefore, within the interest-rate-cutting channel, tightening liquidity is likely to offset the reduction in funding costs brought about by lower interest rates. At the same time, it may also be necessary to pay close attention to whether financial institutions have sufficient liquidity. As a result, initiating a sustained balance-sheet reduction will be quite challenging.

Second, from the perspective of Trump’s policy direction, the sharp strengthening of the U.S. dollar runs counter to his policy objectives.

According to the policy objectives outlined in documents such as Trump’s “Big and Beautiful Act,” the primary goals can be summarized as: orderly weakening of the U.S. dollar to reduce the trade deficit, alleviate the debt burden, hedge against rising import costs, and control inflation. Therefore, the United States remains in a rate-cutting cycle, and Trump continues to urge the Federal Reserve to accelerate the pace of interest-rate reductions.

Typically, during a rate-cutting cycle, a decline in the U.S. policy interest rate intuitively leads to a weaker U.S. dollar. If the Fed were to implement balance-sheet reduction—by reducing commercial banks’ reserves and decreasing its holdings of Treasury bonds and MBS—it would tighten banks’ lending capacity and dampen household borrowing demand, thereby offsetting the weakening of the U.S. dollar caused by the rate cuts. However, the magnitude of balance-sheet reduction is difficult to gauge, and it could push up long-term interest rates, keeping Treasury interest expenses persistently high and thus undermining the effectiveness of the rate cuts.

Moreover, some argue that by controlling the rise in commodity prices, it’s possible to somewhat offset the currency depreciation triggered by interest rate cuts—particularly the price of crude oil, which is linked to the U.S. dollar. However, this runs counter to Trump’s expectation of a renewed recovery of U.S. basic industries and the prospect of manageable energy costs.

Therefore, we believe that during Trump’s term—in particular, until the midterm elections take place—the series of policy objectives he previously outlined, including the expectation of an orderly weakening of the U.S. dollar, will likely persist. As a result, there isn’t much room left for the Federal Reserve to reduce its balance sheet. We’ll need to observe whether, after this short-term nomination process concludes, the U.S. dollar index can return to a more stable trajectory in the period ahead. Whether the Fed will actually proceed with balance-sheet reduction in the future remains highly uncertain.

Meanwhile, gold may experience a significant pullback in the short term due to excessive market heat and the combined impact of event-driven factors. However, under Trump’s strategy of a weaker U.S. dollar, the overall upward trend in gold prices remains unchanged for now. That said, the drivers behind gold’s rise have gradually weakened as changes in U.S. real interest rates have lost momentum; currently, gold prices are more influenced by global investment markets. Therefore, the market’s current focus of speculation may not be on how much interest rates will be cut in the future, but rather on the uncertainty surrounding geopolitical issues and whether the risks associated with the U.S. economy and its debt can gradually be brought under control. The next step will primarily focus on observing whether the market’s preference for U.S. dollar-denominated assets has shown some recovery compared to the previous period; gold price movements may not be as smooth as they have been in the past.

Overall, the global trend toward de-dollarization remains unchanged. As U.S. dollar credibility continues to erode and fiscal sustainability issues stemming from U.S. Treasury bonds persist, we expect the U.S. dollar index to remain relatively low in the medium to long term throughout Trump’s term. Given that the U.S. is still within a window for interest-rate cuts, it would not be advisable for the U.S. financial system—characterized by high debt and large budget deficits—to undertake sustained balance-sheet reductions. Instead, such reductions could serve as tactical measures taken intermittently during periods of significant fluctuations in the U.S. dollar’s price, helping to stabilize the market on an ad-hoc basis.