The Central Bank must unwind their balance sheet of $4.5 trillion carefully or the markets will start become destabilized. The choices to unwind the trade is by selling the bonds or just allowing them “run off”, which means they do not reinvest the proceeds of the bonds. The equities markets has been propped up by the Fed’s use of multiple quantitative easing and that has created a major decoupling between the companies fundamentals from their stock prices.
By propping up the market with money and large cash reserves in companies due to not lending to the average person, simultaneously done with historically low-interest rates, The Fed made most other investments so low yielding that it directly impacted investors decisions to invest in the stock market running that up to all time highs. We have a federally mandated bubble due to the stock market being the only area to find suitable yields and any substantial capital appreciation. By propping up the market I’m referring to The Fed printing trillions of dollars of free money that has artificially inflated the market to all-time highs. Companies were cash rich and the average person couldn’t find any other place to invest.
Now, they must unwind because if they continue down this course of low rates there is a greater probability of high inflation also a bubble forming in both the already lofty prices in real estate and the high hidden valuation of the stock market. I understand to do this correctly they must raise rates at a moderate pace but also be very transparent since any substantial abrupt and unseen decrease in the balance sheet may startle both the markets and investors for a while.
The Fed may want to use a staggered like approach when proceeding with interest-rate raises also providing investors enough of a sign and openness to what they’re planning to do, so there is no panic. If done correctly, this should produce a soft landing. Regarding this way, it gives The Fed complete control and enough adaptability that should change in the US or World economy, they could respond promptly. For instance, if any unforeseen changes happen during Brexit, there is a slowdown in corporate earnings, inflation changes, or instability due to geopolitical events.
The flip side is if The Fed moves too quickly it could send a major shock and destabilize the markets and panic investors. Lowering growth, soaring bond yields, higher borrowing costs, and economic stagnation. Also, the dollar could become very weak, retirement accounts may go down due to a volatile market, and inflation could rise also hurting the average American. It comes down to how The Fed thinks the trade should be unwound and I hope they do so like in 1994 instead of 1937. Either way, I believe we are in for a large correction.