Submitted by Taps Coogan on the 15th of September 2017 to The Sounding Line.

Hoisington Investment Management’s Dr. Lacy Hunt recently spoke with CNBC’s Rick Santelli in order to describe what he believes the impact of the Fed’s balance sheet reduction will be.

Dr. Hunt:

“If we are talking the long term bond yields, central banks have very little influence. Long yields over time are determined by inflationary expectations. Something that’s know as the Fisher equation and the reason that long yields are low not only in the United States, but around the world, is because the inflation rate is very depressed… The action of the world’s central banks, in my opinion, are actually serving to lower, not raise, inflationary expectations. The Federal Reserve has tightened four times. The rate of growth in the money supply is decelerating very substantially. Bank loans have moderated even more substantially than the rate of growth in the money supply. The velocity of money is falling. So to summarize, what I would say is when you have an extremely over-leveraged economy such as we do today, a little bit of monetary tightening goes a long way… “

“The ability of central banks to influence the long term rates by acting on the short term rates in very very limited, and in fact it’s often contradictory. For example, when the Fed was expanding their balance sheet under QE1 and QE2, a lot of folks called that money printing and said it would be inflationary and the bond yields actually rose because the bond market is so sensitive to the rate of inflation. When the Federal Reserve allowed the balance sheet to contract very slightly between QE1 and QE2 and then again between QE2 and QE3, money supply growth came off, the economy decelerated, and bond yields declined…”

At one point in the interview Rick Santelli asks:

“So in that environment balance sheet reduction should be completely smooth sailing?”

Dr. Hunt:

“I believe it will be…”

It is worth noting that in addition to Dr. Hunt’s observations about bond yields reacting inversely to central bank tightening (yields falling instead of rising), banks are holding over $2 trillion in excess reserves. These reserves could conceivably flow into various treasury bonds and make up for the reduced demand for treasuries created by the Fed’s balance sheet reductions, mitigating any large rise in yields.

There is more to the interview, so enjoy it below:

Santelli Exchange: The secular downtrend in Treasury bond yields from CNBC.