One's got to be realistic and face up to the fact that the world has changed.
And that change in the world is partly a function of China and partly a function of demographics.
And the fact is that the West is bust.
And, you know, the reason that the UK goes through prime ministers every two years is simply the fact there's no money left.
They can't fulfil an agenda and they lose the confidence of their party.
But that's the reality. And that's probably a fact across Europe as well.
And then if you look at data that came out of the Philadelphia Fed last week, you're looking at a lot of demand growth in the US economy.
So I think it would be absolutely madness if they tried to do anything like or even got near trying to ease policy.
I mean, it would just be crazy.
I don't believe that that's what they're going to do.
I think the strength or the firmness in the US dollar is actually already telling us that that's the direction they're going in.
They're going towards more tightness.
Let's get into this. Michael Howell, the liquidity king. Thank you for coming on the show. It's good to speak to you.
Well, great. Good to be here, Danny.
I've heard a lot of good things. I know you've spoken to Nick Bartier a lot and James Lavish, the sort of macro people I speak to on the show all the time, all recommended having you on the show.
So I'm excited about this. I don't know exactly the best place to start.
I think maybe we should start off with why you focus so much on liquidity and what it is that means that's the thing you keep your eye on the most within the economy.
Yeah, okay. I mean, it's a good question. I mean, the short answer is that money moves markets. And it's really as straightforward as that.
you know broadly the way that we see things is that what starts the whole cycle or the investment
cycle going is money flows, money coming into financial markets. Economics is downstream of
markets and geopolitics are downstream of economics so you kind of see the sequence of
maybe our thought process but what we really want to understand is is there money coming into markets
or leaving markets that will effectively change transactions. One of the things you need to
think about or conceptualize is that there are broadly speaking two big pools of money in the
world economy. One that's in financial markets and almost a separate one that's in the real economy.
And so many people confuse these two things. They conflate them. They think they're the same thing,
but they're not. They're very distinct. And all money that's anywhere must be somewhere.
so it's either in the financial sector or it's in the real economy. Generally speaking,
as investors, we prefer it to be in the financial or asset economy than in the real economy because
if it's in the real economy, it's just driving activity. Whereas if it's in the financial or
asset economy, it's driving asset prices higher. And that's really what we're looking at. So
that's, I suppose, the sort of the basic thesis.
and when you say economics is a downstream of markets what exactly do you mean that because i
think there's probably a lot of people out there who would think that whatever's happening in the
economy is the thing that's driving markets maybe have that flipped the other way around
yeah i mean see it it basically works the other way well i mean there's there are feedback effects
there's no question but uh you know the real economy will come back and influence financial
markets as a sort of echo effect but the first stage is that money if you think about uh if you
said that money is the important factor that we all need to look at. I mean, I suppose in a
capitalist system, that almost goes without saying. But the fact is that that money process
effectively starts transactions. And typically, you've got to ask the question, how does money
get into or get into our pockets, into our bank accounts or whatever? And it tends to move
first through the financial system. It comes from the financial system. So it tends to stay in the
financial system first. Then it will spill out into the real economies. That's the transmission
mechanism. So we look for guidance as to what's happening in real economies at the financial
sector. And it's so often the case that you've probably heard the line before that the stock
market tends to predict what's happening in the real economy. And that's not really a prediction.
It's more the fact that the stock market is reflecting the surge of money or the fall of money that's hitting the financial sector.
And then there'll be an echo effect later that will affect the real economy.
And it looks as if the stock market's been very prescient in terms of its prediction.
But in actual fact, it's just following the money, which is the important factor here.
So real economies tend to follow financial markets and financial markets tend to be led by liquidity or money flow.
the traditional economic textbooks kind of have things completely arse about face so they you
know you you wouldn't i mean you wouldn't i mean if you were studying economics i would recommend
that people wouldn't you shouldn't pick up an economics textbook because it's it's basically
so wrong uh you know i did uh i did economics through several degrees so i've got a phd in
economics but i must say uh most of the stuff that i've learned about economics i learned in in
in practice in the markets, not from picking up textbooks or understanding what academics say,
because their view of the world is so distorted and actually so wrong that it's actually unhelpful.
And we can have a whole episode on that. But broadly speaking, the markets are the truth
in many ways. And to understand how the markets work, you've just got to effectively understand
money flows. I mean, clearly there's a bit more to it than that. But that's really the essence.
And so what you tend to find is some of the best investors are non-economists, by definition, very far from it.
They actually have much better insight into how markets are working because they're actually using experience or in many ways common sense.
So how have your views on economics changed then?
So obviously you went through a lot of schooling.
I'm sure that was mainly sort of traditional and Keynesian economics.
Have you sort of come around to a more Austrian view of the world?
I don't know about an Austrian view.
I mean, I think there are flaws in both sets of theories. But I mean, the point very simply is that if you, I mean, this is where we start from, is that what you've got to try and understand is the money creation process, how money is being created in financial markets or in the world economy.
and that money will migrate. Money is fungible. It will tend to flow to where returns are highest
or where there are most attractive investment opportunities or buying opportunities. So that
money will flow. But the first thing is to say is that money has to be created.
And that money creation process has a trend to it. There's no question about that. But there's
also a very clear cycle. And it's understanding where we are in that cycle and what's driving that
cycle that's really very important. And, you know, you can, in many ways, dance on the head of a pin
and say, you know, Keynesian economics is the best way of understanding it, or Austrian economics,
or whatever it may be. But, you know, basically, we're thinking much more about cycles, which either,
which, you know, both those two sets of views don't really, you know, explain very well. I mean,
they're explaining disequilibria, you know, when economies have crises or whatever,
but they're not really understanding the fact that what you see most often in markets are fairly
regular cycles and it's a question of understanding why you get those cycles and why policymakers
react in the way they do to certain events and you know what we're seeing now is yet another
example in markets of a typical cycle a cycle in liquidity that cycle has been blown up since
mid to late 2022, we've probably peaked in terms of the liquidity impetus now.
It's beginning to roll over, but you've still got momentum in the system where asset prices
are still rising. But very sensitive asset prices, those that are most sensitive to liquidity,
have already been troubled. I mean, obviously, Bitcoin is one clear example,
which is probably the most liquidity-sensitive asset on the planet.
And then you got gold which is also very liquidity sensitive but that also having a pretty difficult time right now But these are features of the fact that liquidity is losing momentum If you already self Bitcoin you know the deal with hardware wallets
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I definitely do want to get into sort of where we are in this liquidity cycle.
because Luke Groman, who has been on the show a few times, he calls Bitcoin the last functioning
smoke alarm of liquidity. And I've listened to a lot of your work and I know you've said that
liquidity probably rolled over towards the back end of last year. But before we get into sort of
where we are now, can you just explain what drives these cycles? Like as liquidity ebbs and flows,
where is it going to and where is it coming from? Okay. Well, I mean, the answer is actually a
complicated one, but let me try and make it more straightforward by saying, let's say that the main
driver are central banks. I mean, there's obviously a lot more going into it than that,
but let's say it's central banks. I mean, central banks clearly play a very big role.
There are other factors which can influence private sector behaviour in terms of liquidity
creation, but for the moment, let's say it's central banks. So the central banks will begin
to ease policy. Now, what could drive them to ease policy? It could be an external shock,
such as the COVID emergency. It could be a financial crisis like the GFC,
but their response basically is to come in and throw liquidity at markets.
Now, one of the reasons for that, and perhaps the fundamental reason,
is they're not necessarily at the first instance trying to revive economic activity.
what they're trying to do is to bail out the system and maybe bail out the banks
because ultimately financial crises and let's throw covid into that same pot that they're really
refinancing crises and it comes back to the fact that debt is a paramount issue and a major problem
in the world economy right now we have way way too much debt and when i said that if you go back
to economic textbooks, and economic textbooks are wrong or at least misleading, they tend to
depict financial markets as being new capital raising mechanisms. In other words, that if you're
a corporation and you spy some wonderful investment opportunity, what you're going to do is to go to
the capital market, you're going to raise new money, you're going to take that money, and you're
going to invest in new capex, you know, planted equipment or buildings or whatever it may be,
a new enterprise. Well, that's a great idea, but it doesn't really work. It's not really what's
happening now. There's not much of this going on. Now, I would say I'll come quietly and say,
well, okay, I accept the fact that maybe the AI boom is creating this sort of temporary surge in
capital investment. But this has been an unusual phenomenon over the course of the last 10 or 15
years. We haven't really had that much capex going on in Western economies. Most of the capex
that's been undertaken in the world economy as operating in China, and they're clearly not
operating with the same model. This is state-directed investment. So you've got to say
that the textbook model is incorrect. So what are capital markets in the West doing most of the time?
They're refinancing existing debts. They're rolling over debts. And given the fact that
we've got this huge pile of debt, $350 to $400 trillion of debt, with an average maturity
are probably about five years or so. What you're doing is you're rolling over $70,
$75 trillion of debt every year, which is a phenomenal amount of debt roll. And to do that,
you need capacity in the financial sector. You need balance sheet capacity for the intermediaries
to do that. Now, if that breaks down and you haven't got the financial capacity, you're going
to get a financial crisis. So I come back to the shock and say, well, okay, what you've got is a
financial crisis you can't refinance the debt in a capitalist a modern capitalist system where you
have uh where we're credit money we're in a credit money world you simply cannot default debt because
debt is the collateral that's used to basically support the new lending um a lot of lending in
fact something like 70 80 percent of all lending now is collateral based in other words you need
some sort of asset to borrow against. And the bizarre thing is that that asset tends to be an
old debt. In other words, a treasury debt or gilt-edged security or whatever it may be.
So you simply can't default these things. So you basically have to provide liquidity
so the refinancing process can continue. And that's basically the central bank's response
to all financial crises or all of these problems that we see, the tensions in financial markets.
They'll come in on that ad liquidity. That's their ultimate remit. Now, there's other things
they say, oh, of course, we're in the business to control inflation or improve employment. But
the fundamental factor is basically to make sure that debt refinancing continues. And that's what
they do. So if you look at the COVID emergency or you look at the GFC, central banks came in and
poured money into the system. That money inflated asset markets. Liquidity is fungible. So once it
facilitated the debt rolls, it was still there. It basically spilled out into other areas. It
migrated into other risk assets, corporate bonds, equities, et cetera. And it began to inflate
asset markets generally. It's what we loosely call the everything bubble. A good barometer of that,
as you noted, as Luke Roman has said, as we say, is the great barometer is Bitcoin or traditional
monetary inflation hedges like gold. And they clearly witnessed a strong bid during those
periods where liquidity was abundant Now liquidity will then spill out into the real economy ultimately because what you got then is a situation where wealth affects because people
feel wealthier, et cetera, et cetera. They can spend more money. Consumer spending goes up.
The consumer spending may induce further investment spending, et cetera. And then the
real economy gets momentum. Now, as the real economy gets momentum, it will require more
liquidity to keep going. And so it will start to suck liquidity out of the financial sector.
So what you see is the upswing of a liquidity cycle caused by central banks trying to reliquify
the system. And then ultimately, that money's spilling into the real economy and the financial
sector being then or then losing liquidity to a then-born real economy. So one of the things that
you tend to find is a paradoxical feature that strong economies rarely have strong financial
markets. And strong financial markets are often associated with weak economies. And many people,
you know, in Main Street, scratch their head and think, well, we can't get our head around this,
seems to be bizarre. But that's why that works, because you've got these two very separate pots
of money. And it's a question of understanding the sequences. So that's broadly one of the reasons
why you see these cycles. Now, there are other reasons that can come in. It may be that central
banks then get, you know, get concerned about inflationary pressures. And if inflation picks
up because of a strong economy, they will actually initiate a further tightening in financial markets
and that will then cause a bigger cycle. And then we'll get debt refinancing problems because money
in the financial sector is so short and then they'll have to come back in again. So you sort
of see the idea. I mean, we just go 360 degrees round again. And so the cycle continues.
So I know that you've been tracking global equity for quite a long time now. As we get further and
further into this sort of debt spiral that we're in, do you find that the peaks and troughs either
become higher and lower or is the cycle shortening as the debt gets more and more unmanageable?
Well, it's a very good question. I mean, I wish I could be definitive here, but it's very difficult.
I mean, the first point to say is that one of the things that you are seeing is an exponential rise
in debt. And that is almost an arithmetic point, simply because the debt to GDP ratios of most
economies are growing now. They're over 100% in many, many cases. And that means that once
your interest payments start to get of a significant size, the whole thing begins to
compound viciously and you get this sort of exponential growth. And so in order to sort of
to cap the growth of debt, governments will have to go back to fiscal surplus. There's just no
chance of that happening at all. No chance.
Demands for welfare spending or whatever it may be. And the whole welfare system in the West needs
to be radically reformed because it's going to bankrupt countries. And so anyway, that's another
rabbit hole we can go down. But the point being here is that debt is growing exponentially. And
therefore you need liquidity to grow exponentially on top of that. Now, given the fact that liquidity
tends not to grow exponentially, it tends to be more cyclical than exponential, you can see why
you get these financial crises. Now, it would be a nice thing to say that as the world moves on,
you tend to get bigger and bigger financial crises, and you tend to get them more frequently.
that's not always the case i mean i think you can see those tensions building and then being
dissipated um you know at different times you don't always every crisis every subsequent crisis
is not necessarily bigger um but they they're certainly they they tend to have a fairly
constant frequency i mean if you look at our liquidity cycle for example that liquidity
cycle tends to move with an average frequency of about five to six years. Now, why does it move
with a five to six year cycle? The reason for that, and by the way, that's a big contrast to
what people normally cite as a Bitcoin cycle, which is four years, which I don't believe there's
a four year cycle in Bitcoin. I think there's a five to six year liquidity cycle. And my view is
that that liquidity cycle is dominating things like Bitcoin, gold, etc. Now, that five to six
year cycle is occurring because the average maturity of debt in the world economy is about
that tanner. It's about five to six years. And so what you're looking at is ultimately a debt
refinancing cycle as I've described. So I think that's why you get them. So there is a fairly
constant frequency. I don't think cycles are becoming more shorter or more frequent. I think
there's a fairly constant cycle. And you can see at different times, depending on the background,
that those tensions are dissipated sometimes. And at other times, they express themselves in a big
crisis. So is the next crisis going to be bigger than 2008? I'm not sure. There's clearly a case
for that. But it's very difficult to say at this time. It depends on the speed of response of
policymakers. It's interesting. I agree with you that Bitcoin doesn't have a four-year cycle. I
just can't believe there's something special about every 4th October that means Bitcoin has
to crash. But if it did fit into this liquidity cycle, that would give a nice reason that I could
actually understand. So last October, obviously, Bitcoin topped. And I think that coincided with
what you said was the top of the liquidity cycle. Is that right? Correct. Okay. So where are we in
that cycle now and what do you expect to come next? Okay, well, let me see if I can transfer
to some slides. So what this is showing is the global liquidity cycle as we think of it. And what
this is showing is the black line is a rate of change of liquidity through financial markets.
So this is using data, goes all the way back to 1965. It's using data from about 90 economies worldwide. And for each country, we're looking at about 30 different data series. So it's a very comprehensive analysis of liquidity worldwide.
and the black line as i said is measuring a rate of change of liquidity so it's not a level and when
we say that liquidity has peaked we're talking about the rate of change we're not talking about
the level of liquidity just to be clear about that okay now what we've put on top of that cycle
is uh on the top of the black line is a sine wave which for those that are mathematically inclined
has been estimated using Fourier analysis. And that was done actually in year 2000, so
25, 26 years ago. And we haven't changed it since then. And we've just run that sine wave on.
Wow, it's pretty accurate.
Yeah, what you see is what you get. So it's either works or it doesn't, but it seems to be pretty good.
and that analysis was our attempt some years ago to do this. An institution called the Foundation
for the Study of Cycles in the US actually asked for our data last year and they said they'd like
to do a more thorough rigorous analysis because they study cycles in depth and they've got much
better algorithms than we have and they came away looked at the data and came back and said yep we
find it's 65 months too. It seems to be pretty standard and doesn't seem to have changed since
you first estimated it. So that's kind of reassuring. And that's the movement of the cycle.
What you see, as you noted, is that that cycle peaked at the end of Q3 last year. It had
previously bottomed in September of 2022. And that upswing in liquidity has clearly launched
what we've also called the everything bubble. So that's been an important factor in this story.
And it looks as if which is the less good news is that that cycle is going to bottom sometime probably in 2027 and probably the second half of 2027 if I honest So you know we may have some way to go yet And that really the problem that we
face. Now, what about the relationship to things like Bitcoin or crypto? Let me just try and see
if I can show that. Now, so what that shows is the black line is the movements in global
equality on a much higher frequency basis. So what that's doing is looking at six-week changes. Now,
you may well ask, well, why six weeks? And the reason is that basically is a small filter that
gets rid of noise in the data, because looking at week-on-week changes would be hugely noisy.
There'd be no signal there. And a six-week change is basically getting rid of a lot of the noise.
There's still noise in that, but most of it's disappeared. The orange line is looking at a
basket of crypto. So we have this basket we call BES, which is essentially Bitcoin 60%,
Ethereum 30%, and Solana 10% as a sort of broad brush index of crypto. And again,
that six-week changes, the black data series has been advanced by three months, i.e. 13 weeks,
so it's predictive. And that's the tracking that you get. Now, again, what you see is what you get.
We've been using this consistently for many years now, trying to predict what happens in crypto.
the correlation over that period has been about 0.55 or actually higher than 0.55
so in other words an r squared of about over over 0.3 which is pretty good for any financial series
and its latest data is basically showing as you can see this sort of sluggishness if you like in
crypto prices, which is completely consistent with the fact that liquidity is slowed down.
And with gold, would that look very similar to this?
Yes, it would. I mean, there are different dynamics that are going on here.
And one of the things that is, I mean, I don't really get caught in the weeds too much,
but one of the things that we tend to find is that if you look at, I mean, this is maybe not a,
This is not rocket science in the sense that the US dollar area and the Federal Reserve is by definition going to be a lot more important in terms of driving cryptocurrencies than, say, China.
Because in China, you can't buy. It's illegal to buy crypto.
So the PBOC, the People's Bank, which is driving Chinese liquidity, is not going to have any effect on this, or certainly not directly.
So they tend to have more of their influence on gold.
So if I shift to, probably get there if you just bear with me, there's a chart a little bit later I've got which will show this.
This is the relationship between PBOC is the People's Bank of China, and this is gold.
Now, there are a lot of other things going on on gold, affecting gold, central bank purchases, other liquidity, other countries' liquidity, etc.
But you can see that China, just eyeballing that chart, China has quite a big effect on the gold price. And this is illustrating, again, six-week changes to remove the noise, that the PBOC tends to have an impact about two, two and a half months ahead of what happens in gold.
Now, there's a story associated with this chart, which is why we put it up, is that what you've seen over recent weeks is gold weakness.
Now, this is the long-term relationship between PBOC liquidity and the gold bullion price.
Now, this is, I know, a step to the side from Bitcoin and crypto, but it's actually very important in this context to try and understand what's going on because both of these asset classes, precious metals and crypto, are monetary inflation hedges, and they haven't always been aligned over the last few months.
Now, what this chart is illustrating is that people's bank liquidity, the black line, is driving the gold bullion market.
And that's something which is kind of counterintuitive or maybe counterintuitive to a lot of people who have been arguing that the great debasement trade is really what has explained the rising gold certainly over the last year or so.
Now, our point is that the great debasement hasn't really happened yet.
I mean, okay, it's out there. It's going to happen. The challenge for Western countries
is that debt is going to explode exponentially and they will have to monetize and that will
undermine Western financial systems and it will mean monetary inflation in large size.
But it's only China who's really doing it at the moment. And it's very hard to see what China's
doing because they've got capital controls on and money is not allowed to leave or it's not
leaving very easily. And Chinese investors or Chinese residents only vent really for this
excess liquidity is precious metals. And they can put it into the stock market or real estate,
but this is where most Chinese would tend to think about monetary inflation hedges would be
buying gold, and that's what they're doing. So China has to get rid of its big debt problem,
And the only thing it can do is to devalue the yuan domestically against gold. And the reason that they're controlling the gold market, but they've banned people buying crypto because they've realized that that's a very easy way, a very easy conduit for money to leave China. So that's not allowed.
Now, if we go back to an earlier slide, this one, you'll see that there's an interesting conspiracy notion going on here.
This is the data on that previous chart blown up for what's happened over the last few weeks.
And this is the level of Chinese liquidity.
and you can see that almost coincident with the beginning of tensions in Iran,
China basically hit the brakes.
And this is the amount of liquidity in their system.
This is the absolute level.
So the year-on-year growth will actually see a dramatic drop, which it has done.
In fact, I can illustrate that.
You can see the year-on-year drop in terms of Chinese liquidity growth
after this big, big surge through 23, 24, 25. They hit the brakes. Why have they hit the brakes?
They hit the brakes basically because of the Iranian tensions. And they wanted to slow the
Chinese economy down to reduce oil imports during this difficult period. And that's what they've
done. And it looks as if, although the MOU between America and Iran may have just been ripped up,
But it looks as if they restarted their liquidity injections around the time of the MOU signing.
Now, okay, two swallows don't make a summer, but this is not bad evidence to say something's
been going on.
And that may explain gold, and it may explain why you could be seeing over coming weeks
some stabilisation in the gold market if they start to push more liquidity back at the system.
So that's a long-winded way of explaining the role of gold and China in this.
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Yeah, that's interesting. And it's one of the reasons that China has such an impact on gold
that they're moving away from holding things like US treasuries
and moving to hold more and more gold.
Yeah, that's a slightly different point because that's officially.
That's what the Chinese state is doing.
But the big buyers of gold are retail investors largely.
The central bank's also buying gold.
There's no question about that.
But we're looking here at the role of the Shanghai Gold Exchange
and basically retail demand across China,
which is a much, much, much bigger source of buying. But notwithstanding, I mean, you're correct
to say that this is also happening in the background and that clearly is also impacting
the gold price. Okay, interesting. So when the liquidity rolled over end of last year,
Bitcoin obviously fell off a cliff. Is this one of the things where Bitcoin will react very violently,
very quickly to liquidity rolling over? And what will happen next? Is it going to be more downside
for Bitcoin in your opinion?
Or do you think,
does it sort of stabilize here
and wait for liquidity to come back?
Well, I think that,
I mean, put it this way.
I think the first thing to,
if you're bullish on Bitcoin,
I mean, make no mistake,
we're bullish on Bitcoin in the long term.
But the point that I keep making
is that cycles have no respect for trends.
And you've got to understand
where you are on the cycle
to basically benefit
from these long-term trends.
And even if, you know,
Bitcoin goes up strongly over the next few years, it may still be lower by the year end than it is
now. And that's really the risk that we want to try and understand. What I would be doing first
off is looking at what happens to the gold market and whether this China effect in the near term
is going to persist. Now, we know that the MOU has been likely torn up and it may well be that
China decides that it can't afford to press the gas pedal and get the economy restarted because
there's no oil around. So they're going to have to go double down again and put the brake on. I
don't know. We'll have to see how that pans out. That could be the case. But the other thing that's
bubbling away in the background is what's happening in, I know we're sort of straying into the macro
space. So if you want me to stop, I will. No, no, macro is great. But if you look at the
the problem in the US markets, this is really what's going on in the background.
Now, what you could actually argue is that maybe the two most important prices in the world economy,
this is trying to understand what's actually happening to the real economy,
the oil price and the US Treasury yield, have both been suppressed well below their normal equilibrium.
And if that is the case, that's giving a big boost to world economic growth. And if you have strong economic growth, as I've tried to articulate, that isn't necessarily good for financial markets because all money that's anywhere must be somewhere. So if it's in the real economy, it's not going to be in financial markets.
Now, what this chart here is demonstrating is the correlation between the black line, which is nominal GDP growth. So in other words, the value of US national income in current dollars year on year change. Okay, that's the trend. That's the black line. So that's basically nominal economic growth in the US, real growth plus inflation, in other words.
and the orange line is the US 10-year bond yield and I've called it risk adjusted and that takes
out some of the near-term distortions but it's trying to look at the underlying level of interest
rates in the US system. In other words, it's telling us what the market is expecting for
interest rates, policy interest rates, Fed funds over the next 10 years. Now, what that shows
is a remarkable correlation between those two series. Actually, it's kind of what you'd expect,
really. And you can see where we are now. And it looks as if US Treasury yields are well below
where they should be. And the dotted line, the orange line, dotted orange line,
is saying where we expect they may end up. So what you've got is a lot of upward pressure on
bond yields. Now, think of this a little bit like, well, let's say this is suppressed. And think of
this a little bit like holding a beach ball, an inflated beach ball underwater. And the people
that are holding it down are the US Treasury and the US Federal Reserve, because they want to keep
their interest bill low, and they want bond yields to be suppressed, because that's kind of helpful
to the economy. So they're doing all they can to keep these yields down. And a number of things
they're doing are they're very active in what's called the repo markets. Repo markets are basically
at the centre of funding in not just the US, but in the world economy. And it goes back to a
statement I made right at the beginning about how the world is dependent on collateralised finance.
And what that really means is that prior to the global financial crisis in 2008,
banks would lend freely to each other without any security. They did it on trust, okay? There was a
lot of trust in the system Following the global financial crisis not surprisingly lenders wanted a bit more security So what you had is this sizable jump in the use of collateral and the repo markets effectively intermediate that collateral
So in the repo markets, that's what repo stands for sale and repurchase. What you're actually
doing is you're effectively borrowing against collateral. That collateral tends to be something
which has got well-recognized value, like a US treasury bond, is liquid, is secure, etc.
So you'll post a treasury security to your credit provider, and he will lend against that. Maybe
they'll lend 98% of the value against that collateral, 95% or 90% or whatever it may be,
and then you can get a loan. And that's what the repo markets do. And the treasury
and the Fed have been intervening heavily in those repo markets to basically keep, if you like,
the pot boiling and the treasury market yield suppressed. Now, to use that beach ball analogy,
you're basically holding the beach ball underwater. Now, there's a couple of problems in that.
One is this one, which is what happened to Japan when it tried to hold its beach ball underwater.
and this is looking at the US JGB market, Japanese government bond market. The dotted line
is my estimate of what the fair value is on the Japanese long bond, the 10-year bond.
And you see those figures, I mean, roughly for a long time, about 1%. But actually,
through that period, Japanese yields, the actual yields, the solid line went negative.
Because of their yield curve control program.
Yeah, it was all this yield curve control and whatever else.
Now, as soon as they stopped that yield curve control, the fair value of the market went up,
that dotted line, but also the actual market overshot. And you can see what's happened is that
you've got something like, I mean, at least a 200 basis point jump in yield since the ending of that
yield curve control program. Now, given the fact that the starting point was basically around 50
basis points, we're now up at over 2, 2.5% for JGB yields at 10 years. I mean, this is a phenomenal
change. The world's never seen anything quite like this. And this is what can happen. So if you're
holding that beach ball on the water and suddenly let go, it shoots higher. Now, the problem you've
got in the US is basically this one. And this is showing the pressures at the front end of the US
term structure. This is getting a little bit in the weeds and I'm going to try not to do this too
much. But basically what this is telling us is that if you squeeze hard on one end of a balloon,
it's going to bulge somewhere else. So you can't stop that. So if they're squeezing hard
at the sort of 10-year, longer-dated area of the market, it's going to be bulging elsewhere in the
term structure and it's bulging at the front end. And what this is basically illustrating
is those pressures. Now, the orange line is the two-year treasury yield in the US.
And that's a very, very good marker to what the private sector markets believe
policy rates will have to do in the US. So it's a very good sort of indicator based on supply and
demand as to where interest rates will really be set over the next two years. And can I just ask
you a quick question on this chart? Because a friend of mine, Jeff Ross, uses this chart a lot.
And the thing that he often says is this proves that the market actually decides the rates,
not the Fed. Is that what you see when you look at this?
100%. That's exactly what we've been saying. It's always the case that it's the long end of the
market that determines the short end of the market the federal reserve is is not i mean can influence
things in the very very very short term but there's not much it can do and that's really the
point but that shows what a tricky spot that kevin walsh is in now because he's obviously
been brought in to lower interest rates but the market's saying no like what do you think he will
do well i just don't think he can he can't he can't ease because i mean what you're doing is
you're stoking a fire already because the US economy is already growing very fast.
And if you look at, I mean, these are sort of economic statistics I can throw out,
but if you look at US money supply measures, I mean, we don't look at money supply
to understand financial markets, really. We look at money supply to understand the real economy.
and the latest m2 money supply data or let's actually incorporate not the latest but of about
a few weeks ago maybe four or five weeks ago the rate of growth of the rate of monetary growth
was up at close to 10 okay um a three-month annualized rate i mean it's called a little
bit since but that was clearly a big spike and then if you look at some data that came out of
the Philadelphia Fed last week, and you use that data, which was showing a big jump in activity and
still very high inflation pressures, that's pretty much consistent with nominal GDP of about nine,
possibly 10%. So you're looking at a lot of demand growth in the US economy. So I think it would be
absolutely madness if they tried to do anything like, or even get near trying to ease policy.
I mean, it would just be crazy. I don't believe that that's what they're going to do. I think the strength or the firmness in the US dollar is actually already telling us that that's the direction they're going in. They're going towards more tightness.
This chart is telling us that. And if you look at the net difference, which is shown here, as the spread between SOFA rates and the US two-year Treasury, that negative spread is telling you, rather like it did in 2021-22, that we've got a tightening regime upcoming.
Now, that tightening regime in 21-22 caused the S&P to fall 25%, and it caused Bitcoin to fall 75%.
Now, I'm not going to say you're not necessarily going to get a repeat of history, but just be careful.
It's really interesting.
Do you think part of this is why Kevin Walsh has come out?
He said he wants to create an inflation task force to kind of get back to first principles of what inflation is.
and he said that he cares about the left side of the decimal place, not the right.
So essentially saying he'll go up to 3% inflation.
Is this him trying to figure ways of manipulating the narrative
and doing what he actually wants to do?
Well, I think he's giving himself some degrees of freedom, that's for sure.
I mean, I don't know the exact figure, but it's something like,
is it 63 or 64 months now since the Fed last hit its 2% inflation target? I mean, it's so long ago
that it's almost ridiculous that they're still trying to target 2%. I mean, the underlying
inflation rate in the economy is much higher than that. And they simply can't recognize that
because it will then become embedded in expectations. So they've got to keep the sort
falsehood, they're still trying to target 2% inflation. But I think what he's doing is being
realistic and saying well okay let give ourselves a little bit of flexibility because that will mean I may not have to tighten as aggressively as maybe I should do But you know then again you know the cynic in me says that you know all these little tools that or tricks that policymakers are using
are really just telling us that they really want to raise rates quickly. They want to keep this
thing going as long as possible. But the problem is, you know, using the beach ball analogy,
maybe events overtake them and they have to start to tighten aggressively at some stage.
I mean, you know, not being early in the tightening causes you to do a lot more overkill later on.
And so when, like, to use your analogy, when they let go of the beach ball, what happens?
Is that sort of financial crisis in the US?
Like, how does that play out?
Well, it could be.
I mean, that's, I mean, never say never.
So this is my measure of where you get disequilibria or financial crises, to use a less poetic term, financial crises in the system.
And this is looking at what I define as the debt liquidity ratio.
Now, if you come back to the sort of opening statement I made, which is to say, you know, financial crises or financial markets more generally are about refinancing.
I mean, it's all about refinancing debt.
And that's the main role of a financial market.
So if you see a financial crisis, it's because you can't refinance, you can't roll over the debt.
And effectively, there is default threatened because that debt cannot be paid back.
Now, what happens in those situations is you get a cascade into a crisis.
And that tends to occur when the debt liquidity ratio is so stretched that there's insufficient
liquidity, in other words, balance sheet capacity among financial lenders to roll over the debt,
to provide the balance sheet space to do that.
And that tends to occur at levels, as you can see here, at around about 220, 230 on that chart.
Now, 200, which is the long-term average, I don't know why, but that's where it is, seems to be a level of some stability. And anything above that, you get a financial crisis, which I've annotated. So all these past financial crises have tended to occur when you get very high debt liquidity ratios. And that comes back to this whole point about refinancing debt.
And if you look at the lower part of the diagram, when there's lots of liquidity relative to debt, what you find there is you get asset bubbles because the vent in the financial sector of too much liquidity is ultimately an asset bubble.
Now, what we've just come through is what I've loosely called here the everything bubble, where you see huge liquidity relative to debt.
That's not because debt is small.
It's largely for two reasons.
One is that liquidity has grown enormous because the response of policymakers to every crisis, be it COVID or the GFC, is just to throw liquidity at the system.
You know, spoiler alert there.
Everyone should be owning these monetary inflation hedges long term, like crypto or gold, parche the cycle.
But this is their response.
And if you want an insurance policy against it, you've just got to own these monetary inflation hedges because they will go up dramatically in that environment.
So that's one thing.
And the other thing is that because policymakers recklessly decided they were going to slash interest rates to zero or even negative in cases, it caused people to term out their debt.
So in other words, if you had borrowings, if you were sitting in the COVID crisis in 2020 and saw interest rates of zero and negative, you thought, well, great, I've got debt which is maturing in three years. Why don't I just refinance it now for another seven years at zero or 1% and I'm quids in? And that's what happened.
So if you look at this chart, this is showing what I call the debt maturity wall, which is
basically saying, and this is not the absolute level, this is the change in the amount of debt
that needs to be rolled each year. So in 2021-22, there was a big drop because investors turned out
their debt and a bit in 23-24. And now you start to see from 25 onwards that the amount of debt
that needs refinancing is growing all the time. And this is existing debt, it's not new debt. So
you've got to add on to that, you know, the amount of funding that the US government will require
because of defence spending, you know, what European governments will require, what the AI
capex boomer require, all these things are adding to this, which is purely, you know, the debt in,
that's expiring the existing debt, if you like. So that's really the issue that we're facing
upcoming. And it comes back to this general statement, which is talking about the debt
liquidity cycle. And this is the centerpiece of our analysis, which says, look, financial markets
are debt refinancing mechanisms. It's all about this interaction of debt and liquidity.
Liquidity needs debt because most lending is collateralized. Debt needs liquidity because
debt has to be rolled over. So you get this sort of nervous equilibrium between debt and liquidity.
And if that derails, on the left-hand side, you can't turn your debt into liquidity.
You get problems in the repo collateral markets, which is why things like the SOFA spread or the
move index, I mean, I'm getting into the weeds of this for most people, but that's when they tend to
signal flash warning signs. And then on the right-hand side, because something like 70% of
80% of all transactions in financial markets are rolling over existing debts, you're going to get
problems either in bond term premia, which collapse, or you get credit spreads which blow out.
And there's a big move towards safety in that space. People are nervous because debts can't
be refinanced. So that's how the system works. And that debt liquidity nexus at the heart of it
is basically shown here in this debt liquidity ratio. And you'll see the gray area that we project,
that orange line goes up. Why does it go up? It goes up because A, the cycle in liquidity is
turning down for the reasons that we've gone into, and B, because you've got this debt maturity wall
upcoming, which is causing debt to come back that needs to be refinanced. So that's the problems
we've got. And that's why I would be hesitant about diving in now. Don't try and catch a
falling knife. Just wait for things to stabilize and try and get a reasoned view because Bitcoin
and gold will pick up dramatically in the medium term. But I wouldn't necessarily be
an aggressive buyer right here. It's interesting. Anyone who knows about Bitcoin knows that this
isn't something you buy for six to 12 months. This is a long-term buy. But when this liquidity
cycle does reach its bottom, is there always a catalyst that turns the liquidity switch back on?
Well, I mean, the biggest is a financial crisis, yeah.
But I mean we not getting a financial crisis or are we going to get a financial crisis every six years or however long this liquidity cycle actually lasts Well I mean that really been the pattern But I think we can debate are they big or are they small liquidity crises
I mean, if the central banks are alert, they're relatively small ones.
We saw there was a repo crisis in 2019.
There was the COVID crisis, 2020, 2021, etc.
uh there's been a bigger you know i'm actually maybe that's that's a that's a bad the covid one's
a bad example maybe the big the the bigger crisis was the one the post-covid tightening uh which was
20 21 22 probably so you can see you you've got this sort of pattern unfolding um and it's not
exactly every five to six years because things you know nothing is perfect but you get that sort of
that frequency and that uh and that's what we've got to we've got to look at i mean that you know
I mean, we made a statement.
I mean, this is going back a long time, back at the time of the GFC, is to say that what
you've got is a future which is going to be dominated by QE processes.
And don't think of QE1 or QE.
Think of QE1, QE2, QE3, QE4.
You're going to get a series of these quantitative easing processes because that's what central
banks are in the game to do now.
The debt has become such a problem that they need to refinance debt and they need to reliquify periodically the financial system because it can't cope. And that's the issue. And all this talk about, you know, brave talk about the Federal Reserve balance sheet is going to be shrunk dramatically. I mean, dream on. There's no way they can do that.
Well, that's always the question I have. The debt problem is obviously ever growing. How do they ever get out of this? Do you think their plan is to inflate their way out of it? I can't see them ever defaulting. So what other options do they have?
Well, they have no options. They can only inflate. Because in a modern credit system, as I said, the paradox that you've got, if you look at this chart, I mean, basically, liquidity depends on debt. Okay, so liquidity, call that new credit, depends on debt. But that's old debt, right? So the debt that they're using as collateral is existing treasury debt for the most part, okay?
So you can't let defaults happen because you're basically undermining your whole credit system. So if that's ruled out, all you can do is basically print money to devalue. That's what the Chinese are doing.
But the issue I think we've got to get our heads out of or people have got to accept is that the sort of debasement of debt, the great debasement as people talk, hasn't happened yet.
We haven't had that period.
We're getting it in China, right?
And the Chinese have sort of managed to do it through capital controls and whatever else.
I mean, that may be a pointer to the future.
I mean, it may be very difficult for Western governments to impose capital controls, but it doesn't mean to say they won't try. And you can see that in many cases. I mean, already they're starting to try and stop, trying to direct capital into local schemes, whether it's Trump's attempts, make America great again, whether it's the attempts that the British socialists are doing.
I mean, all these things are ways to try and corral money and stop it flowing to where it should flow, which is monetary inflation hedges when they're basically printing money.
But, you know, as I say, the thing to think about is that China is really the country that's tried to get to grips with its historic debt problem.
okay the debt problem the west faces is a future debt problem much more than a current one do you
think they've got any chance of growing themselves out of this debt and obviously ai being the the
sort of only obvious catalyst no i don't think they've got any chance at all um because you know
you're in a situation where you know growth for the most part i mean i'm not going to discount ai
and say that innovation technology is not any good.
But the fact is that a lot of growth is very demographically sensitive.
And the growth rate of economies is really, at the end of the day,
dependent upon young workforces.
And we don't have that.
Yeah, demographic problem.
It's super interesting.
I've really enjoyed this, Michael.
If for anyone listening to this who wants like an actionable thing to do, what is the move here?
Like, obviously, the debasement trade isn't a trade that lasts a year.
This is a long term trade.
Is it still buy gold, buy Bitcoin?
Yeah, I think it is.
I think it is to do those things.
That would be sensible.
I think you've got to, you know, also think about the jurisdiction, the geographical jurisdiction of your investments.
and you know i'm not giving recommendations because i don't know the answer but you know
i think that if you start to get uh if you start to get cases where it's going to be very difficult
for certain governments to fund themselves uh um you know let's go close to home with britain
i mean if you've got a socialist agenda which allegedly you have being written down in the uk
now i mean bond vigilantes worldwide are not going to be wanting to fund fund this at existing
interest rates. So how are they going to try and get this stuff funded? Well, there's going to
have to be directives to pension funds or wherever it may be to try and force them to put money into
the UK. And that clearly is something which is going to constrain investors' ability to invest.
So I would diversify. That's the best thing. I think gold and Bitcoin are clearly international
assets that can be held. But I think one's got to be realistic and face up to the fact that the
world has changed. And that change in the world is partly a function of China and partly a function
of demographics. And the fact is that the West is bust. And the reason that the UK goes through
prime ministers every two years is simply the fact there's no money left. They can't fulfill
an agenda and they lose the confidence of their party. But that's the reality. And that's probably
a fact across Europe as well. I think you can probably short any country that's bringing Gary's
economics on as an advisor. That's probably a safe bet. Michael, this has been fascinating.
Thank you so much for coming on the show. Where can people go and find more of your work? I know
you have a sub stack. Where do you want people to go and follow you? Best way is the sub stack,
I think that's called Capital Wars.
And we write a lot of stuff.
You know, we do narrative provide data.
We do two or three pieces a week.
We talk about crypto, gold, asset allocation,
Fed policy, China, all these things,
which we think are relevant.
I'll make sure I put all the links in the show notes,
but thank you so much for this.
We'll have to do it again when,
maybe when the liquidity cycle is turning again.
We can be more bullish on Bitcoin then.
Great.
Perfect.
Thank you.
Thank you so much.