Michael Howell - Global Macro Series - September 21st, 2022

[00:00:00] Michael

As the world gets bigger, financially it becomes more volatile. I think the reason for that is that basically you’ve got a situation where liquidity is ever expanding and solvency is in progressive decline because the quality of debt, at the margin, is continually going down. The quality of that debt is deteriorating, and that’s really a function of the huge amounts of debt that we’ve got that the world economy has got itself saddled with.

[00:00:29] Introduction

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Before you make investment decisions. Here’s your host veteran hedge fund manager. Niels Kaastrup-Larsen.

[00:01:30] Niels

Welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is a series that I not only find incredibly interesting as well as intellectually challenging, but also very important given where we are in the global economy and geopolitical cycle.

We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro driven world may look like. We want to explore their perspectives on a host of game changing issues, and hopefully dig out nuances in their work through meaningful conversations.

So please enjoy today’s episode hosted by Hari Krishnan.

[00:02:15] Hari

Thanks very much Niels for this introduction. My guest today is Michael Howell, managing director of Crossborder Capital in London, and author of Capital Wars: The Rise of Global Liquidity, which was published by Paul Grave McMillan in March 2020. It’s a real pleasure to have Michael on the show, and as a side note, I did work with Michael for many years in the UK, and it’s great to have him back.

It’s great to speak to you, Michael. Thank you.

[00:02:43] Michael

Good. Great to be here. I look forward to the chat. 

[00:02:48] Hari

Great. Why don’t we start with a little bit of your background, and how you came to write the book. 

[00:02:53] Michael

Okay. To start at the beginning, my first sort of entry into the world of finance and capital flows was really with Salomon Brothers, the American investment bank. For those people that don’t know Salomon Brothers was the sort of preeminent fixed income trader worldwide.

It was in many cases the bond market for many countries, and Solomon’s business really depended on understanding flows of money and how flows of money were moving around the world. It was identifying those flows, and trying to understand them, that was really the key input into our research process.

[00:03:28] Hari

Great, and then what led you to start Crossborder Capital? 

[00:03:31] Michael

I think to extend on that idea, the whole idea about monitoring capital flow was a critical one. Back in the mid 1980s, when I started to do it, it wasn’t really very well understood.

Not many people track capital flows. In actual fact, in truth, the capital flows had only recently been deregulated worldwide. Although the U.S. still had an open capital account for a long time, many European economies, in Japan even, had closed capital accounts.

There wasn’t really very much activity. It was really from around the mid-seventies, but particularly in 1979, when Margaret Thatcher basically got rid of UK exchange controls, that the whole international cross-border market began to spiral upwards. There was exponential growth. Monitoring that market, and trying to understand the implications for fixed income, for FOREX markets, and ultimately for equity markets, was a critical research tool.

We did that at Solomon Brothers for many years. I then moved to Barings. Barings was the key investment bank for emerging markets. So, we extended the framework into emerging markets from the early, early 1990s, and then Barings, as probably people remember, had their own issues. Ultimately, we decided to quit investment banking in general and go into investment advisory. It was probably a safer business, so to speak, certainly more solid. So, since the late 1990s, Crossborder Capital was founded, and we set ourselves up as an investment advisor. We do both research markets. We provide a lot of data on the liquidity flows and capital flows worldwide. We also have a division which runs money based on that information input. 

[00:05:14] Hari

Of course, I need to ask you the obvious question then. What exactly is liquidity, at least according to your definition? 

[00:05:21] Michael

Well, I think the easiest way to define it is probably in its simplest form. It’s the total amount of savings and credit that are flowing through world financial markets. One of the things that we stress right out front is this is not money supply. Money supplies, people understand it. It’s really a retail concept. It’s really about the amount of deposits that are held by retail investors in major High Street banks. Our definitions of liquidity pretty much begin where those more conventional definitions of money end.

So, we are looking very much at a financial market concept. We’re looking really at the capacity of the financial system to let’s say refinance positions. The main thing that we emphasize in all our research is that the nature of the financial system is very, very different from the standard textbook view.

The standard textbook view is that financial markets are there for new financing. In other words, the finance capital spending or whatever. That no longer is really the case, particularly in the West. You will recall that most capital spending anyways is now done in China or in Asia, the West doesn’t really do very much CapEx anymore.

Most of the time capital markets are really engaged in refinancing activity. That is rolling over existing debt. I’ll come onto the magnitude of that in the second. But the point about liquidity is that liquidity is a measure of the capacity of capital in the system. The ability to refinance positions fundamentally. 

[00:06:52] Hari

Understood.

In terms of order of magnitude type estimates, how much debt is there out there in the world? How much of it needs to be rolled over? 

[00:07:01] Michael

I think this is the key point. What you’ve got at the moment is levels of debt, which are about $350 trillion. So that’s about three and a half times world GDP.

Now the average maturity of debt is around about five years. So that would suggest that what you’ve got is around $70 trillion of debts that need to be refinanced every year. Now, if you contrast that with new capital spending, the world economy, as I said, is about a hundred trillion. About one fifth of that is devoted to capital spending. and about half that capital spending is externally financed through capital markets. 

Which makes a figure of around about $10 trillion for new capital issues. So, the $70 trillion of refinancing of existing debt is seven times the $10 trillion of new financing for new CapEx. So, capital markets are very much about refinancing activity.

The point about refinancing is that interest rates matter to a lesser extent than the ability to get the role. If you need to refinance your position because your debt is maturing, what you’ve got to do is to make sure that you get that role. If you don’t get the role, you’ll default. Or if you are a mortgagee, you’ll find yourself homeless.

So, it’s the role that is important. The capacity of capital in the system, in other words, liquidity really matters. That’s one of the points that we keep stressing. We think central bankers have really lost sight of that. They focus too much on interest rates, and particularly low interest rates.

The problem with low interest rates is they compound the problem by encouraging more and more debt, hence you know, frequent financial crises. 

[00:08:47] Hari

Can you say anything about trends in the growth of securitized lending versus non securitized, and how that relates to the treasury market?

[00:08:57] Michael

Yeah, absolutely. Particularly since the global financial crisis in 2008. The vast majority now of credit and liquidity flows are collateralized, and securitization in some form is a key part of that. Prior to 2008, there was a lot of unsecured lending, in other words, lending based more on trust.

But really since that sort of watershed moment in 2008, the vast bulk of the financial system is really dependent on collateral. That collateral is something which looms in the background. It’s a critical thing to understand, because in many cases, or for many markets, there is a shortage of collateral.

Now, what does that really mean? What it really means is that there’s a shortage of good quality assets that can back loans. Now, those high-quality assets, or so-called pristine collateral, are things like U.S. treasury notes and bonds, UK gilts, German bunds, for example. Those are all assets, government backed assets, that are used as collateral in many financial transactions.

One of the ironies that we’ve had in the last 10, 15 years since the financial crisis, is that number one, government austerity policies have actually reduced the supply of this pristine collateral. Secondly, you’ve got central banks engaged in quantitative easing policies, and those quantitative easing policies basically vacuum up a lot of those pristine collaterals, leaving the private sector short. You can see the problem in many cases, if you look at things like term premier in the bond markets. 

Now term premier is a slightly wonkish concept but let me just try and explain what a term premier is. A bond will have really two moving parts. One of those moving parts is interest rate expectations, in other words what investors consider the future path of policy interest rates to be over the term of the bond.

The other element are factors, which will then alter the price of the bond depending on supply and demand factors along the term structure. So, for example, if regulation forces investors to hold more government bonds (in other words, they’ll force pension funds to hold more bonds, or banks to hold more bonds) there could be an excess demand for bonds at that particular tenor. That will then cause term premier to be depressed, may even be negative, and it will cause distortions in the shape of the yield curve. Now, one of the things that we’ve seen over the course of the last 10, 15 years, as I say, is a tremendous demand for these safe assets. There’s a shortage of supply.

On top of normal demands, regulation is increasing the whole time. For example, the bonds with three regulations, the solvency with two regulations that affect insurance companies (the former affecting banks) basically means that you’ve got a very healthy, ready demand for safe assets in the system and there’s just not enough around. 

Consequently, one of the warning signs I would suggest that we all ought to be paying a lot more attention to is the fact that in the U.S. treasury market (the centerpiece of world financial markets in many ways,) you’ve got the lowest ever reading for bond term premier at the 10-year tenure, which is normally taken to be the benchmark bond – the 10-year. The lowest ever, and it’s very negative. That must be telling us something about risks in the system. 

It’s either saying that bond investors are discounting a huge upcoming recession (maybe that’s true) or it’s telling us, as well, that there’s a structural shortage of collateral in the system. That may well be true as well, and/or is telling us that there’s a big shortage of liquidity? That’s one of the things that we currently are emphasizing or are warning about that liquidity is basically getting scarcer, and scarcer as central banks withdraw cash.

[00:12:46] Hari

So, let me see if I can piece this back together. So, you mentioned an estimated $70 trillion role per year of refinance debt. If I understand correctly, there’s about $20 trillion of outstanding treasury debt in existence? 

[00:14:20] Michael

Yeah, exactly. Exactly. 

[00:14:28] Hari

That’s roughly the right number, and every time the Fed engages in QE, they basically swap debt for reserves, and reserves are not useful as collateral.

[00:14:38] Michael

Correct. 

[00:14:40] Hari

So that causes a further constriction in the available supply of treasuries. 

[00:14:44] Michael

Correct. 

[00:14:46] Hari

Now, why would that cause a dip in longer duration treasuries? Why wouldn’t short term treasuries be even more desirable as collateral than longer term ones? 

[00:13:31] Michael

I think there are a number of reasons for that. I mean, one is that you’ve got different audiences in the market, or different constituencies, that demand different types of safe assets. For pension funds, you would tend to find that the 10-year bond is the critical one to look at. 

What’s more, if you felt that a recession was upcoming, the 10-year bond would offer quite a lot of safety, because it would typically rally more in an environment where interest rate prospects were starting to go down, or investors generally wanted the safety of a government bond. The impact of their demand on price would be much greater.

So, in other words, there’d be a lot more leverage for the investor effectively in that 10-year bond. At the front end of the curve, the treasury bill, or maybe a one on two-year bond, certainly in demand as well. There’s no question about that. But it’s the longer-term bond, which is really the focus of the market.

The 10-year bond tends to be, as I say, a sort of benchmark issue. But you’re undoubtedly correct, there’s also demand for shorter data stuff too. 

[00:14:33] Hari

Understood. One thing that you point out, and it’s even suggested in the name of your firm, is that cross-border flows are extremely significant.

I know that various people have increasingly understood that they are significant. There are people like Jeff Snider at your Eurodollar University, and so forth, who emphasize this very strongly by the way. Can you say something about the nature of the offshore market in dollar lending? How it differs from what goes on in the U.S. and how it may be outside the control of the Fed? 

[00:15:08] Michael

Yeah. The offshore market is a somewhat nebulous beast, because nobody really knows the true size of it, but what it basically consists of are offshore dollar, and actually, currencies, but mainly dollar deposits.

So those international currency deposits are outside of their normal jurisdiction. So, for example, it could be U.S. dollars held in London, U.S. dollars held in Frankfurt; it could be Sterling pounds held in New York, et cetera. So that offshore market is really outside of normal regulation of the central banks. It’s offshore pools of money. That tends to be very fast-moving money. It’s money that is in the financial system, and it will move around. So, for example, if U.S. banks become short of liquidity, they will often go out to the Eurodollar market to tap into it. So that tends to be a source of marginal financing.

It really depends on, I think one’s one sort of view generally, about how important those offshore markets are relative to the central banks. Now regarding the Eurodollar markets, the other question to address is their relative importance in terms of driving global liquidity. I think it was unambiguous that if you go back to the time of 2008, or pre-2008, that the offshore markets were a dominant feature. They were in many cases driving a lot of the flows internationally. 

Post 2008 has really been a different question. Whereas in the lead up to the global financial crisis, the central banks to a large extent have been muscled out of the credit creation process. What they’ve done since 2008, through regulation and through massive balance sheet expansion, is really to muscle back in again.

I think it’s a moot point today whether the central banks are now equal or even more dominant than the Eurodollar markets. In many cases, even if you look at the supply of dollars internationally, the Federal Reserve is now a major supplier through swap lines.

What swap lines mean is that the Federal Reserve has effectively opened branch offices around the world in friendly economies, to supply dollars when needed if those financial systems ever become short. I think that’s a critical factor, which we can cut back into later on. If you want to address the Bretton Wood System, or as people are now talking about Bretton Woods two, or Bretton Woods three, in terms of international finance. 

It’s safe to say, I think the conclusion I would bring out of this is that cross-border flows are important, still very much important, but the central banks have really come forward, in the last 10, 15 years, to become the dominant players again. The two big central banks that one has to pay considerable attention to are the Federal Reserve, needless to say, but also the People’s Bank of China. Those are the two big players in the system right now.

[00:18:01] Hari

Perfect. Now that brings me to two questions. The first one is, you mentioned these swap lines with friendly nations or friendly counterparties. I presume China is not one of those friendly nations, and that probably leads right into some of the issues you address in the book. 

[00:20:15] Michael

Correct. Yeah. 

[00:20:16] Hari

The second question, (the questions aren’t that closely aligned, but nonetheless), as far as I know, the People’s Bank of China, the asset side of their balance sheet is smaller than the ECBs, last time I checked. It’s not much bigger than the BOJ’s (the bank of Japan’s). So why is the People’s Bank of China so significant from your perspective?

[00:18:46] Michael

Okay. So, let’s dive straight into the PBOC, in terms of the People’s Bank, the people’s bank has very tight control, or exercises very tight control over the Chinese financial system in a way that the federal reserve probably does now but didn’t pre-2008.

The Chinese financial system is a nascent financial system. It’s nothing as complex as a Western country, particularly the U.S. It’s pretty straightforward in terms of the type of institutions and the type of instruments they trade. Because of that, the People’s Bank can actually exercise pretty tight control.

There are clearly very large state banks that listened to it directly. In many cases, the operation of the PBOC, or the way it controls the banking system, is very similar to the way that the Bank of Japan controlled the Japanese financial system through the 1980s.

Actually, pretty much the same as how the central bank of Korea controls the Korean financial system. It’s really through window guidance. In other words, what the central bank does is it has lending targets that it gives to the major state-owned banks. They can lend to particular industries, and that’s really how credit creation occurs.

Now, whereas the People’s Bank, as you are probably correct to say, may have a marginally smaller balance sheet now than the European Central Bank. It has been larger, relatively speaking, or sorry, it has been larger and absolute terms than these, the other players. It was actually even bigger than the Federal Reserve at one stage, about two years ago.

It’s also been very fast growing. The other thing is it has a major effect on the credit aggregates in the Chinese economy. Now, even though the PBOC is smaller, as we note than some of the other central banks now, it’s not a big difference, but Chinese liquidity is hugely bigger.

The pool of Chinese liquidity represents about 33%, or one third, of total global liquidity worldwide, actually even surpassing the U.S. domestic liquidity. So, this is a big, big player in the system. The PBOC is an important lever in terms of controlling Chinese liquidity.

[00:18:46] Hari

Is it fair to say (sorry) that as always in financial markets, the rate of change of some quantity is as if not more important than the size, as price movements occur at the margins? Is that one of the things you’re pointing to?

[00:23:32] Michael

Yes. I think that’s certainly one of the factors. Chinese liquidity has grown, spectacularly even if one goes back to the year 2000. If my figures are correct, or my memory’s correct rather, Chinese liquidity was then about 8% of global liquidity.

In 20 years, it’s muscled forward to basically become a third of global liquidities. There has been absolutely phenomenal growth. Now the point about China and understanding China, is that China’s economic footprint is huge. Its financial footprint is basically at the moment, a lot smaller, but China wants to get that footprint larger.

In order to get that financial footprint as dominant as its industrial economy, what China needs to do is to internationalize the Yuan. Now, paradoxically at the moment, China is a major re-exporter of dollars, from what it should be doing is exporting Yuan into the world economy.

It’s simply not doing that, but that’s what they intend to do. There are very clear policy statements that the Chinese have made, and I put some sort of one or two quite delicious quotes, one in particular that comes from a general, a prominent general in the People’s Liberation Army, who’s often a spokesman for the administration in China, who actually says explicitly that a goal of China is to displace the U.S. dollar as the major currency within the Asian region. He’s explicit to say that the Belt and Road initiative is one of the programs they’re using to actually lever up the Yuan in terms of internationalization.

Now, the program that China is likely to engage in to get there really consists of three different legs. In my view, anyway. The first of those legs will be to redenominate trade in Yuan. Now, is that an easy task? Actually, the answer is relatively easy. China is the world’s biggest importer and exporter. Most of that trade is currently conducted in U.S. dollars or invoiced in U.S. dollars.

At the stroke of a pen, it would be feasible for China to change that invoicing into Yuan. Now from that base, China could then create a trade credit market using Chinese banks to intermediate the flows. That was exactly paralleling what U.S. banks did in the wake of World War I, when the British banks actually stepped back from international lending during, I think it was during the war, but it was around 1915, 1916.

The U.S. muscled in. The U.S. dollar became the dominant international currency within a very, very short space of time. By the early 1920s, most countries foreign exchange reserves were dominated by U.S. dollars. Sterling had been elbowed out. Therefore, one’s got to consider the reinvoicing of trade to be a major threat to the dollar in the longer term.

Now is China intended to do that? My answer is absolutely it is. Otherwise, why would China be engaged in swap lines? I think there are currently 36 swap lines between the People’s Bank of China and other regional central banks. At the moment those swap lines must be set up for future trade flows, to finance future trade flows.

The second thing that China needs to do is to open up its bond market to international capital. Now, partially what’s happened this year, where there’s been some retreat of international capital, the opening up of the Chinese bond market to foreign investment has actually been very successful. It has attracted a lot of inward capital. Given the yields that are on Chinese bonds that would likely be a future avenue as well to exploit or to further.

The third thing is to look at digital currencies, and China, as we know, is well advanced on digital Yuan. That will facilitate peer-to-peer transfers. It will try and get over the trust issue, which is clearly nagging the establishment or internationalization of the Yuan, but maybe a digital currency with transparency will help to get around that. Actually, laterally the Chinese have partnered with other BRICS economies to set up an international currency rival to the dollar. Which was an announcement they made in The BRICS Conference, in June of this year. So, there is clearly some momentum going on.

My view is it will take a long time for China to get there. But, as the Chinese say, every journey begins with one step. This may be a 10- or 20-year journey, but they’re definitely embarking along that route. What the Chinese are trying to do is exactly what the Europeans tried to do in the 1960s and 1970s.

That is to eliminate the exorbitant, or so-called exorbitant privilege, that America has with the dollar, that it can actually gain seigniorage. So called seigniorage, which is actually the ability to buy real resources with paper assets, because you’re a global reserve currency. China wants its slice of that pie, and it’s trying to get rid of America’s exorbitant privilege and replace it with Chinese exorbitant privilege using the Yuan.

[00:26:06] Hari

Why hasn’t China opened its bond markets up to international investors?

[00:26:11] Michael

Well, it has, but I think the general point is why are there capital controls, which are basically stopping the exit of more, particularly the exit of Chinese capital internationally? Well, the answer is that, I think, because a lot of Chinese would see that as a wonderful opportunity to get their money off shore.

Now we saw a taster of that in 2015, 2016, when in its endeavors to join the IMFs currency, the SDR. One of the preconditions for that was that China had to drop its capital controls, and it did that. The problem was that dropping of capital controls coincided with the anti-corruption drive of Xi Jinping, and consequently, a lot of money left China and went actually into the U.S. dollar. There were huge capital outflows. It weakened the Yuan, and it basically spooked the Chinese sufficiently for them to slap capital controls back on pretty quickly. I think that’s always a risk. I think like many things in China, this is going to be a controlled process.

Don’t expect an overnight big bang, but China is basically angling towards internationalizing the Yuan. The ideal situation for them would be to have basically capital controls, preventing Chinese capital leaving, to allow foreign capital to go in, and basically to have convertibility on current account for trade reasons.

So that would be an ideal mix, whether they get there, who knows. But I think their determination is there, and they want to internationalize the Yuan. Now, if you want to continue this story in maybe a more speculative vein. I think one of the things to start pondering is what China has been doing since 2016 with its currency.

In 2016, there was a rumored agreement that came out of the Shanghai G 20 Conference. Which basically supposedly was an accord, which was an attempt to then weaken the strong U.S. dollar. Out of that Shanghai Accord, there followed a period of about five years of remarkable stability across Asian currencies, with the Chinese Yuan really being at the center of that block.

What the Asian economies were doing was creating a defacto Asian Euro. Now that may be a sort of rather fanciful thought, but if you look at the evidence, as they say, if it’s yellow and quacks, it’s a duck. Basically, for that five-year period, volatility across the Asian currencies, talking about cross currency volatility here of the cross rates, fell below the volatility seen during the Bretton Woods period.

So, you had a defacto fixed currency block operating. Now that fixed currency block is likely to be a platform, or was designed to be a platform, I would imagine, for China to further its ambitions of internationalizing the Yuan. China’s central bank was intervening in the money markets. It was easing and tightening policy.

So, it stabilized the value of the Yuan against other crosses. That much was clear, and China’s monetary policies have been dictated through this period by the idea of stabilizing the Yuan. The old idea, the old policy idea of growth at all costs for China, where they were goosing their economy at any opportunity to try and manufacture huge growth, stopped in 2016.

The era of stability, particularly Yuan stability, was launched. Now that ended very abruptly in late February, early March this year. Without necessarily getting into conspiracy theories, it occurred about a week or so after the invasion of Ukraine. What basically happened was that the Chinese Yuan came under pressure, but it came under pressure because the Japanese Yen was in free fall. Through a period, I think it was a period from early March to early May, the Japanese Yen devalued at an annualized rate of 82%. 

Now in all my years in financial markets, I’ve never seen a currency or markets do that to a currency. Only governments do that. Now it could have been, as some people have suggested, an astute move by the Japanese to try and improve their competitiveness. But, hey, there were no shouts of foul or unfair play by the U.S. treasury, when only 18 months earlier with a lesser devaluation of the Vietnamese Dong, the U.S. treasury were jumping up and down complaining.

But in this case, nobody saw a word, not even the Japanese. They allowed this massive devaluation of the Yen. Now that put a lot of pressure on the Chinese Yuan. It put a lot of pressure on the Korean Won, which basically went and devalued alongside the Yen. But the Chinese throughout was struggling to hold the level of the Yuan up against the then raging U.S. dollar, and the collapsing other Asian currencies.

The Chinese did that by taking a lot of liquidity out of their financial markets. During that period in the second quarter, a period where the Chinese PBOC normally injects all of liquidity to Chinese financial markets, they withdrew a hundred billion dollars equivalent out of those markets. That is not a central bank that is determined to ease monetary policy. They are tightening. 

That’s one of the reasons that the Chinese economy is on its back. Not just because of the COVID problems but because liquidity has been tightened. As a result of that, what you’ve seen in commodity prices and commodity markets coming under a lot of downward pressure because of that tightness and the reversal of the Chinese economy.

I think this was a deliberate policy, maybe engineered by the U.S. treasury and in cahoots with the Japanese as well, to try and shake the tree and put a lot of pressure on China. Our view through this year has fundamentally been that what you are looking at is monetary policy in the U.S. which wants to get the dollar up and the federal reserve balance sheet down.

[00:32:15] Hari

In any case, let me ask a slightly more speculative question, which is that let’s say that Chinese denominated debt became as liquid as U.S. treasuries (or nearly as liquid), and it was postable as collateral, as high-quality collateral in global repo markets. What impact would that have on the U.S.?

[00:32:36] Michael

I think that in that hypothetical (and we got to stress as a hypothetical situation), in that hypothetical situation, China would be a clear rival to the U.S. The point about being able to internationalize your currency is really a question of saying, what sort of resources can you buy internationally? How can you use your capital to dominate? That really comes back to the title of the book, which is Capital Wars. 

What it’s trying to understand is that maybe that threat of when does Chinese capital face off the U.S. in terms of international rivalry? It may well be that wars are fought much more in terms of financial markets and capital flows today than, actually, troops on the ground. That’s maybe the issue. But I think that if you saw a situation where China was operating along those lines, one question would be, who would recognize that debt as collateral? That presumably would be countries within a Chinese domain.

Let’s say that there is a world economy that is cleaving into two halves: one which is a dollar zone, and one which is maybe a Chinese Yuan zone. The Chinese would then be in a situation where they could lend against that Yuan bond collateral within that domain, presumably the countries in that domain would be some Asian countries, presumably Russia, presumably North Korea, presumably Iran, maybe Saudi Arabia, maybe Brazil, maybe South Africa along the BRICS lines as well.

But you’ve clearly got challenges then to the dominance of the U.S. dollar. What you’re really saying, Hari, is that, what is the possibility of there being two worlds out there: one being financed by dollars, and one being financed by Yuan?

And I think the reality is that may be the way that we are going. Now, have we seen that before? I think we have seen that before. We saw that in what people refer to as the original Bretton Woods agreement. Now it’s very fashionable today to talk about Bretton Woods two and Bretton Woods three.

In many ways, I didn’t think that Bretton Woods one ever really went away. There have been different arrangements in the international financial system, but basically the parameters of the original system still remain very much in place. Those are: number one, the dollar at the center of the whole process, that still is very true today. Maybe the dollar is actually, ironically, even more dominant than it was back in those days. The second thing is you’ve got policing of individual countries’ finances by the IMF and the World Bank. So, if any particular country gets into payment difficulties, the IMF or the World Bank can actually come in and reorganize and restructure them. The third thing is, (which, again, we mustn’t lose sight of) is that the whole system is backstopped by the U.S. military. Now, why is that important? It’s important if you’re looking at trade flows and one of the issues to face up to is what happens in a situation where you’ve got large distances to take goods by ship?

I’m thinking here maybe of Gulf oil and the role of the U.S. military in that arena is clearly very important. Now, if the U.S.  backs off, in that regard, are the Chinese able to safeguard their own trade with the Middle East in terms of being able to allow the Chinese Navy to escort tankers? I don’t think they have the facilities to do that yet. Geographically it’s difficult; militarily it’s difficult. This is all part of this whole question about capital wars and international currency. 

The last thing I’ll say about the Bretton Woods deal is that the Bretton Woods deal (Bretton Woods one so-called), was the domain of Brenton Woods one was the free world. It clearly excluded the People’s Republic of China, and it excluded the Soviet Union. It was basically allowing capital and trade flows to move around the free world. That’s what we are going back to, quite rapidly, in my view. 

I think that’s endorsed by the statements that Janet Yellen made, particularly the speech at the Atlantic Council (I think it was in May of this year) called “friend-shoring,” and the follow up speeches that Blinken made about China, about a month or six weeks later. What they’re doing is underscoring the parameters of a new Bretton Wood style world, where friend-shoring is basically allowing trade and capital flow and dollar lending and borrowing in a situation or in a group of friends.

It’s friend-shoring. It’s friendly nations that are getting together. You’re either in with the U.S. or you’re against the U.S. I think that’s become very clear now.

[00:37:20] Hari

Winding back the clock from the hypothetical to the present, another major point in the book, as I understand it, is the increasing network risk within the financial system and the increased probability of financial crises that actually have a knock-on effect onto the real economy. Can you say something about that and what has triggered this, and how bad it actually is at this point?

[00:37:44] Michael

Yeah, I think one of the points to note or to accept is that whereas financial markets were, in many cases, the servants of the real economy historically, it’s almost the other way around now. The financial markets have become dominant.

If you look at the business cycle, it’s very much a cycle in the financial markets. When you get booms and busts in financial markets, you often see that mirrored subsequently in the real economy. So, for example, after the 2008 financial crisis, we got a recession. In the lead up to the financial crisis there was a housing boom, I’m sure everyone will remember. It was one of the factors which helped boost economic activity. You can see very much, even if you go through and look at the (in detail) the emerging economies, the emerging markets economic cycles are increasingly led by financial cycles. Those financial cycles, in turn, are often driven by cross-border flows. 

So, the financial sectors are important. What we’re seeing now is a significant downturn in financial markets and, low and behold, I think that most people are predicting that we’re going to get a recession coming out of that. So, I think that finance is very important in that regard, and we’ve got to pay attention to it. Now that may not be the ideal situation to be in, but it’s a fact. Financial markets are dominant and we’ve got to understand liquidity flows and how they operate and how they influence financial and economic movements. 

[00:39:07] Hari

Would you say that the periodicity of the cycle has shortened or has just the amplitude, or the extremes gotten wider?

[00:39:18] Michael

If you look at the evidence, the evidence seems to show that the amplitude has changed. We’re seeing bigger swings and I’ll maybe come to a reason why that isn’t a moment. But I think the other thing is that the frequency seems to be pretty constant. We tend to think that the financial cycle lasts around about 65 months. If you trace the cycle going right back to the early 1960s, that frequency seems to have been pretty much intact, but the amplitude has changed significantly. 

So, whereas before it was a relatively mild cycle, now it’s actually quite a fierce cycle. Now I think the reason for that is that what you get is a lot more leverage in the system. You also get a situation where central banks, if they want to make an impact, have to expand their operations in a much greater size because they’ve got to expand into lot more entities or they’ve got to seep into a lot more avenues or cracks, or whatever, to actually get to solve problems or to actually restrain the system.

We spoke earlier about the Euro/dollar markets [and that] in order to tighten the system, during the era of Euro/dollar dominance, the central banks had to run ever tighter monetary policies to try to make sure that liquidity was tight domestically, and there wasn’t sufficient offshore to bail out domestic banks in that case. I think that the amplitude has certainly become a lot bigger. 

The other thing that you’ve got, in the background, is that inevitably you’re getting a situation which is that as the world gets bigger, financially it becomes more volatile. I think the reason for that is that you’ve got a situation where liquidity is ever expanding, and solvency is in progressive decline because the quality of debt at the margin is continually going down. The quality of that debt is deteriorating. That’s really a function of the huge amounts of debt that we’ve got that the world economy has got itself saddled with. 

Now, I think there’s an interesting question here, which is beginning to be thought about more and more in academia: what is the correct monetary policy in this world that I describe as being a world dominated by refinancing rather than new financing?

There’s an echo here (for those that are interested in history) that goes right back to the 19th century. In the 19th century the London financial markets were very much refinancing markets, but they were refinancing trade bills very often. You did see periodic crises. Out of those crises, a big one being in 1866 with the Overend Gurney; Overend Gurney was a major bill breaker. It was a (what we now call) shadow bank. It was the world’s biggest financial institution, but it basically defaulted and was not bailed out by the Bank of England at the time. Now that sent shudders through the London markets and out of that a journalist called Walter Bagehot (later known for a book called Lombard Street, which has made him the doyen of central bankers now) wrote about the ideal central banking policy which was to lend at a high rate of interest against good collateral. In other words, to lend freely, at high interest rates, against good quality asset backing. 

Today that message has been completely lost because central banks are doing the absolute reverse of that. They’re lending at low interest rates. They’re not lending very much at low interest rates and they’re lending against poor collateral. What they need to do is to change. Now, the problem that the central banks have got themselves into comes back to a general problem that many of us face which is the entry of China into the world economy. That formally came with China being allowed into the world trade organization in 2001. From that point China was able to flood the world with very cheap goods. As many people remember, that was the era of disinflation or very low inflation for many, many years, if not almost two decades. That spooked central bankers in the West because one of the things they’d been taught was to avoid deflation. It was considered to be a major bogie that price inflation was too low.

You see the problem in spades, in Japan, through this period. Japan, even today, is very concerned about low inflation rates. A lot of that is coming through from cheap Chinese goods. What central bankers did, to avoid deflation, was to keep interest rates at very low levels. The problem is that what they muddled up was something we called cost deflation with monetary deflation. Monetary deflation is a bad thing. Cost deflation is a good thing. But they muddled the two up, they fudged the two things together and they said, “This is deflation period, it’s probably monetary deflation so we’re going to keep interest rates low.”

The problem with doing that is if you have low interest rates you encourage debt. What you’ve seen through this period, associated with or paralleling China’s entry into the world economy, is a massive take up of debt in the West. So, we’re saddled with this huge burden, which is $350 trillion – three and half times world GDP which has to be financed.

That has turned the Western financial markets into refinancing mechanisms rather than new financing mechanisms. As I come back to it, refinancing mechanisms are all about liquidity, not about interest rates. What you need to do is to think about the level of liquidity in the system, but you also need to get interest rates up to try and stop this appetite or this huge enthusiasm for debt, but you’ve got to keep the liquidity there so at least you can finance what you’ve got. 

[00:44:53] Hari

Let me sketch out a scenario then. I’m not a hundred percent sold on this, but I’d be very interested to hear your insights. Let’s say that yields at the 10 year point blew out pretty rapidly. Would that have an impact on the repo markets? Would the value of the collateral be viewed differently for short term lending or would that not be a major thing?

[00:45:11] Michael

The answer would be that it would not be positive that’s for sure. The fact that it depends on the range of collateral that you are looking at. Basically, if you’re looking at pristine collateral, which is government bonds, if you’ve got relatively short duration bonds, the impact of higher interest rates are not going to have that material effect. That’s obviously why they’re held as collateral. Clearly as you move through the capital stack and you start to go towards lower and lower quality collateral, it’s going to have big effects. The answer is it’s not bullish if interest rates go up to that extent. It really highlights the vulnerability of the system and that it means that central banks have always gotta be alert to this.

If you see situations where interest rates are going up, sharply collateral values are falling, or there’s a shortage of good collateral (which is the situation now anyway), and you’ve got a lack of liquidity, you are going to see major financial problems and central banks will have to come back in.

I think there’s no mistake, and we ought not to delude ourselves that central bank balance sheets are going to shrink forever. They’re not, they’re going to be expanding again pretty soon. We’re in a world of permanent QE and permanent QE means that, because liquidity is fungible asset markets generally will inflate over longer term.

People may say okay, this is just a sort of greater fall theory, maybe it is at the end of the day. The fact is though that we are kicking the can down the road, but maybe it’s quite a long road. This may go on for 20 years, 30 years, 40 years.

Just take a look at debt levels in the West higher as they are. and as burdensome as they are, they’ve been higher in the past. We could easily double the debt levels from here and still be breathing. The world financial system will be a lot flakier, a lot more fragile, central banks would have to do a lot more to keep the plate spinning but we’d still be operating.

I think the reality is that the path of least resistance is a path which says we take on more debt and central banks are ever present, but we’ve really got to get off this. The only way to get off this is to keep interest rates high over the medium term. 

[00:47:14] Hari

It may sound simple minded, but isn’t a higher level of yield, also good for the banking system because it encourages them to lend or the price of lending is more transparent in some sense?

[00:47:25] Michael

Yeah. banks typically make more money when you’ve got fatter interest margins, for sure, yeah. A higher interest rate environment tends to be generally pretty good for the banking system. I would hesitate to say this, but I think the problem is not really in the High Street banks right now. The problem is in the general architecture of the financial system. If you go back to 2008 it was the shadow banks that were really the problem. The traditional High Street banks weren’t the solution. Regulation was focused very much on traditional banking even though they weren’t really the culprits in 2008, but that’s the easiest institution to regulate. Generally speaking, I think it’s the whole architecture of the system which is the problem. 

[00:48:07] Hari

On that point, I’m somewhat obsessive about order of magnitude estimates. I can look back and see that the Eurodollar market may have been $10 to $15 trillion, let’s say in 2010 making up a number, but that’s roughly correct.

Has it grown much since then? Has the offshore short term lending market expanded or has it flatlined? 

[00:48:27] Michael

The estimates that the BIS put out are of the magnitudes that you correctly say: of the order of somewhere between $10 and $15 trillion is the size of offshore dollar lending.

It has often been claimed that the Eurodollar markets, maybe a lot larger than that in size, in truth. At the end of the day, as I say, it’s a fairly nebulous figure. We don’t really know. Relative to that time, the Eurodollar markets really flatline. They haven’t done very much.

Part of the reason for that was that there was a legislative change in, I believe it was probably 2018 (if I remember) when there was a tax amnesty that came out of the Trump administration. U.S. banks were encouraged to repatriate funds to the U.S. That took a lot of the steam out or the impetus out of the Eurodollar markets at the time.

So, this is part of this general remit that the U.S. authorities have to try and take control of the credit system again. It’s part of what they were doing with the Federal Reserve et al. In my view the central banks are bigger than the Eurodollar markets now, but they certainly weren’t 10, 15 years ago.

[00:49:37] Hari

What makes it so difficult to estimate size? Is it the provocation of securities again and again, the chains of interdependencies or is it simply that we don’t have even basic data in that space?

[00:49:52] Michael

Yeah. It’s all of the above. They’re not reported numbers. They’re estimated numbers and, as you rightly say, there’s provocation, there are chains of lending, et cetera, yeah. 

[00:50:05] Hari

Now the I know that there’s some secret sauce here, so I won’t try to reveal that, but how do you go about in your research business making some assessment about, at least at the very least, the rate of change in the size of a market such as this?

[00:50:18] Michael

In terms of the cross-border markets, let’s take it step by step. In terms of the cross-border markets, we can monitor flows into and out of these markets. The actual stock size of the market is the question that I was raising. We don’t really know what the stock size is. That may be an issue or even the turnover. What we’ve got a fairly good idea about is some of the flows. That’s one of the things that we can monitor.

The flow data that comes out of the U.S., which is the so-called TICs data is not necessarily a true indication of dollar flows because a lot of those dollar flows occur in offshore jurisdictions such as Bermuda or Cayman or whatever.

So, what we tend to do is look at the other side of that to track it. [We] look at money that is flowing into the U.S. from Asian or European entities. So, we look at it really from the other side. That’s one of the ways we capture the data. 

In terms of the general picture of liquidity, what we are looking at is we’re monitoring central bank activity that is looking at both the size and the composition of central bank balance sheets. We look at the private sector, and that really comes down to three or four entities. It’s looking at High Street banking (the credit supply of High Street banks), the credit supply that comes through the shadow banking system, and also the savings flows of the household sector, and the cash flow of the corporate sector.

All those four entities are basically sources of funds. We very much take a flow of funds view of the world, which goes back to my heritage Solomon Brothers, Henry Kaufman, who was the head of research at Solomon Brothers and a well-known name in the markets in the 1980s and was already a pioneer of flow of funds accounting and analysis in the U.S. financial markets, and that legacy maintains.

[00:52:14] Hari

Now my perception of this is that your methods, your research methods are particularly valuable at extremes in the cycle or as the economy or the liquidity cycle heads toward an extreme. Is that fair to say? 

[00:52:27] Michael

Yeah, I think absolutely. I think that inflection points are critical. What you really need to know is where you are in the cycle in particular, but more particularly, are you at an extreme, are you close to a turning point or not? One of the things that is going on right now is that the liquidity cycle is heading down sharply. We are not yet at the trough, but we’ve collapsed in terms of our index numbers.

We use indexes of liquidity. We published a monthly index of global liquidity, but also indexes for 90 odd countries as well within that. The global liquidity index was, let’s say, 15 months ago was around 90 of a range between zero and a hundred. It was up at 90. So, it was very high.

The latest reading is about 23, so it’s come right, right down, particularly in the last six to nine months as central banks have been tightening significantly. 

[00:53:16] Hari

One other area that I think you’ve added tremendous value in my humble opinion is in the currency space. I think there’s some insights that you have that many people perhaps aren’t aware of with regard to relative liquidity, both in the private and the public sector across countries.

Maybe you could say something about that. 

[00:53:34] Michael

Yeah. Let me say a little bit about that. In terms of what drives currencies there are two traditional views. One is interest rates, relative interest rates. I’ve never found great success at that. It’s a nice idea, but it tends not to work very well in practice. The other idea is looking at relative monetary growth. Again, that has plausibility, but it’s not a particularly good guide. So, people come to the conclusion that currencies are very difficult to predict. 

What we do is that we look at different types of liquidity. We separate what you might think of as private liquidity from central bank liquidity. Private sector liquidity creation in a currency area is positive for a currency. So, if the U.S. economy is growing fast and it’s generating lots of cash flow, banks can be lending on good quality projects, et cetera then it’s quite likely the currency will be strong because the return on capital in that country is strong and money will be attracted into it. At the same time, central bank liquidity is a negative for currency. So, if the Federal Reserve is printing lots of dollars, then the dollar will weaken. 

What we look at is we distinguish between the two types of liquidity, and we effectively look at the spread between them. If private sector liquidity in the U.S. is strong, and the Federal Reserve is running a tight policy, then what you’ve got is the recipe for a very strong dollar. That has really been the case for much of the last 18 months or so. What you’ve seen is either very strong cash flow coming out of U.S. corporations and U.S. businesses at the same time the Federal Reserve has been running an increasingly tight policy over recent months and through that period of the dollars remained, throughout, pretty strong. 

[00:55:11] Hari

Understood. So, if the Fed is tight, the message is the dollar is likely to be strong because the supply of dollars globally is restricted. 

[00:55:20] Michael

Yeah. Unless the U.S. economy goes into deep recession and cash flow gets disturbed (private sector cash flow), then the dollar could weaken. 

[00:55:28] Hari

For non-dollar crosses. Is the method equally valid?

[00:55:30] Michael

Yeah, it’s exactly the same methodology. And we look at crosses using those same metrics. 

[00:55:37] Hari

Just, I know we’ve jumped around a little bit, but is there anything you wanna say about the current regime beyond what you’ve already said?

And then we can perhaps end with a few parting comments. 

[00:55:46] Michael

Sure. I think the environment right now is one where liquidity is being tightened dramatically. If I was a central bank, I would be very alert to falling term premier in the bond markets, in many cases collapsing term premier, and the very fact that the term premier are negative.

They shouldn’t be as negative as they are now, and they certainly shouldn’t be falling. That’s telling us something about dangers in the system. In other words, there’s a great move of risk-off in the bond markets. That’s not a great feature. Also, if you look at primary dealer statistics in the U.S., you’ll see a progressive climb in numbers of failed trades. That also is not a particularly good indicator. 

It’s telling us the liquidity conditions are tight. Central banks are determined to reduce the size of their balance sheet. The Federal Reserve is saying they’re going to cut the balance sheet by about a third. So, bringing it down from about $9 trillion to about six and a half. That is a huge contraction of liquidity.

The Federal Reserve claims that’s equivalent to about 25 basis points on Fed funds, so they dismiss it. They say it’s a bit like an air conditioner whirring in the background. I think it’s a lot worse than that. It’s a wrecking ball not an air conditioner. And that degree of slashing of the balance sheet, in our estimation, is equivalent to about five percentage points on Fed funds. So, we’re looking at a big, big squeeze if this goes through, 

The short answer is it won’t happen. There’ll be disaster before then. The financial markets will see dislocation, the world economy and the U.S. economy will be in recession and there’ll be some policy pivot in 2023 (probably led by more liquidity rather than a quick cut to interest rates).

The dollar will remain strong. The threat to the dollar is a collapsing Euro, which looks to us inevitable at some stage given the pallor of the situation of the European economies. Their very muddled monetary policy and a collapsing Euro will not be good use for the U.S. and the U.S maybe will try and engineer a soft dollar coming out of that – if that’s a likelihood. Financial markets are in a difficult situation for six months, but I would be looking to buy and reenter financial markets aggressively sometime in early 2023. 

[00:57:51] Hari

Now this sort of brings us to a slightly more technical issue, which is the location of the Fed pivots.

It’s moved around quite a bit. I think several months ago it was June 23, then it pulled into March, and it’s been quite volatile. If you just look at the Fed funds, futures curve as a simple proxy. How does that relate to the leads and lags in terms of Fed policy transmission? Do you think the tightening has a quicker impact than easing or vice versa?

Do you have a handle on what you think the lag might be between economic conditions and tightening of the balance sheet? 

[00:58:26] Michael:

Yes. The lead time tends to be about eight to nine months. Liquidity has a bigger effect if there’s a dearth or an absence of liquidity.

If the Fed has taken a lot out and begins to put liquidity back in, it will have a refreshing effect quite quickly. So that lead time might come down. But one of the things to remember is that if you look at the history of financial markets, generally, there’s been about a nine-month lead time between changes in liquidity and subsequent changes in the market.

At the low point of the market, when the S&P is traditionally below its trough, what you tend to see is the maximum easing by the Federal Reserve. So those two things historically have correlated together. In other words, the Federal Reserve is easing before the market reaches its bottom.

[00:59:17] Hari

Expectations management, which is a phrase that’s bandied about quite a bit nowadays, where the Fed is actually affecting markets, simply by what they say, or their communications is that something you’re skeptical of because it doesn’t have a real data driven foundation or does it have an impact on lags?

[00:59:35] Michael

Yeah. I’m extremely skeptical about that. I think that the central banks have obviously got to throw out a framework – a stable framework. I think that Bernanke was cynical enough to say that central banking is 98% words and 2% action. I think that’s ridiculous.

Clearly it isn’t because the size of the balance sheet is so important. Now I’m sure they know that, but I think this is just for general consumption. In the same way, I cannot believe that the Federal Reserve would realistically say that a one third reduction in their balance sheet is only equivalent to 25 basis points on Fed funds. Common sense tells you it’s a lot more than that. I think that a lot of this is for public consumption. 

[01:00:15] Hari

Understood. Well, we’ve covered quite a few things and I’d like to end by highly recommending Capital Wars. I think it’s an excellent book. It ties together a lot of issues that people are concerned about nowadays geopolitical and market.And it does it in a very data driven and detailed way. So, congratulations for that. 

[01:00:34] Michael

Good. Thank you, Hari. Been a pleasure. 

[01:00:36] Hari

Thank you. My pleasure. 

And with that, I’d like to hand it back to Niels

[01:00:39] Niels

Thank you so much, Hari and Michael, for a fascinating conversation. The topic of capital flows and as Michael puts it, capital wars, is incredibly important as it ties into the whole question about market liquidity and what really drives this.

I must say that the issue of corporate’s ability to roll that debt, now standing at a total of $350 trillion (or the same as three and a half times world GDP), and with an average life of only five years, that means that about $70 trillion has to be refinanced every year. Now this is something that I’m not sure if investors are fully pricing into their risk models, but perhaps they should.

And when you look at some of the tension we see from an economic perspective on a global scale, then clearly the U.S. Fed retains the upper hand in its battle over currency supremacy for now. But on the other hand, China is attacking. In other words, the capital wars have already started. 

Make sure you go and follow Michael’s and Hari’s work because as you can tell from today’s conversation, there are many exciting facets to learn from those who have been in the trenches for many years. And we really look forward to exploring many more of them as our series continues. 

From Hari and me, thanks ever so much for listening and we look forward to being back with you on the next episode. In the meantime, take care of yourself and take care of each other. 

[01:09:50] Ending

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