The Global Economy from a Liquidity Perspective ft. Michael Howell

[00:00:07] Michael

So, if you think that we’re going to see these types of increases over the next 25 years, just looking at compound interest, growing at that level means that the stock of liquidity is going to expand by about tenfold between now and 2050, which means the gold price, if it keeps pace pari-passu, is going to go up ten times as well. So, you’re looking at $25,000 an ounce.

[00:00:34] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes, and their failures. Imagine no more.

Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world, so you can take your manager due diligence or investment career to the next level. Before we begin today’s conversation, remember to keep two things in mind. All the discussion we’ll have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance.

Also understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:30] Niels

Welcome, and 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 the 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. Please enjoy today’s episode, hosted by Alan Dunne.

[00:02:14] Alan

Thanks for that introduction, Niels. Today, I’m delighted to be joined by Michael Howell. Michael is MD of Cross Border Capital, which is an advisory and research firm focused on capital flows. He is also an investment manager running fixed income and FX mandates.

Michael has been in the markets many years, going back to the 1980s, spending time at Salomon Brothers and Barings before founding Cross Border Capital. He’s also the author of Capital Wars.

Michael, great to have you on. How are you?

[00:02:43] Michael

Well, great pleasure, Alan.

Yours is one of the top five podcasts I always listen to regularly, so it’s a great honor to be here. I’m doing well as well, so thanks.

[00:02:52] Alan

Great to have people on who are high-quality guests and also willing to speak favorably about the podcast, so thanks for that. You’re not a new guest on the show. You’ve been on with Hari Krishnan, going back a couple of years, back in September 2022, so we won’t go into the whole background. I referenced your time at Salomon Brothers and Barings, but for anybody who’s interested in getting the full story, we’ll point them to that episode.

I think it would be useful to reiterate your framework for looking at markets, which is all around liquidity. So, if you wouldn’t mind, maybe starting off with why liquidity matters, how you think about measuring it, and how does that relate to your analysis of capital markets?

[00:03:37] Michael

Okay, well, let me have a bat. Basically, our whole philosophy surrounds global liquidity, the idea that liquidity or flow of funds is important in markets. Understanding where the money is, really is what’s driving everything; driving asset markets and ultimately driving the re-economics.

That particular philosophy was one that was very deeply embedded when I was at Salomon Brothers. That’s really where, I guess, I learned those skills. It was then very much a US focus, and what I tried to do was to say, well, look, the world is becoming more international.

That was actually, as you or others will recall, that became actually quite a sudden event in financial markets from the mid-1980s onwards. The world suddenly became international. It was very important to understand what the Bank of Japan and ultimately the ECB and now the People’s Bank of China are doing.

So, flow of funds are really a critical thing. And then understanding the whole, if you like, the transmission mechanism through financial markets by looking at other concepts, such as duration; how duration is affected by liquidity, et cetera. And these were sort of ideas that were very, as I say, very well embedded in the Salomon Brothers.

Marty Leibowitz was the architect and the doyen of duration and understanding duration in fixed income markets. Of course, Henry Kaufman was the doyen or originally the real architect, or one of the original architects, of flow of funds analysis. So, I owe my career or my thinking very much to them.

And what is it we mean by liquidity? It’s basically the flow of funding liquidity or funding through markets. It’s the total amount of credit that’s issued by banks and shadow banks, plus the savings that can be taken from households or corporations.

It’s generally a measure of the balance sheet capacity of the financial sector. So that’s really what we think about. And in terms of how does that operate, in terms of how it fuels markets, we think of asset markets as having two moving parts.

One is the flow of liquidity or global liquidity, and the other is the risk exposure of that money, the deployment of that money, which we think of as the risk exposure of investors. So, you’ve got two moving parts.

And I think to maybe set up where we are now, our view is that the liquidity cycle continued to expand. It bottomed around October of 2022. It’s been moving higher since that time. One would have to say that, in cases, it’s been a relatively slow evolution, but it’s still going up.

And what happened in the last few weeks, the last three to four weeks, with the chaos and the yen carry trade is basically a change, not in liquidity, but it’s actually a change in the risk exposure of investors. That is, as we talk now, seems to be coming back again. The investors are taking on more risk as they probably should.

[00:06:34] Alan

Good stuff. I mean, we’ve heard a lot about liquidity, I guess, over the last 10, 15 years. I mean, ever since the global financial crisis, which was, I guess, maybe started as a liquidity crisis, and then it was more of a solvency crisis.

So, there was a debate along the way. And then we had a whole raft of liquidity measures that were brought in by the central banks. But then post-GFC, obviously, quantitative easing was the big thing.

And it’s easy to see how QE is an injection (or it seems to be) of liquidity. You take out bonds, and you buy bonds, and you put cash into the system. And then that gradually percolates into risk assets by what I think is called a portfolio rebalancing mechanism or something like that.

So that seems quite intuitive. And I mean, sometimes you hear in the media saying, oh, equities went up last week because liquidity expanded and the PBOC did something. And it seems a bit tenuous because the Bank of China did something that US equities should rise.

But is that the type of analysis that you think is valid? Can you draw that transmission mechanism from, say, a central bank in Asia to US equities?

[00:07:46] Michael

Well, I think you can. But I would say that certainly a lot of the talk is often loose about what happens. I mean, people can ascribe movements in markets today to what the Bank of Japan or the PBOC did last night. I think that’s probably a little bit generous.

That’s much more about the risk exposure of investors; much more the flow of money or liquidity in the markets. The flow of liquidity operates over, let’s say, a medium-term period. So, it’s much more likely that the actions of the People’s Bank of China or the Federal Reserve maybe three or four months ago, or maybe six months ago, is having an effect now on markets as that money is percolating through.

And that’s really how we see it. So, the liquidity cycle we envision is a cycle that lasts about five to six years and not five to six days or five to six weeks. So, it’s really a medium-term cycle.

And I think you’ve got to look at it in that way. Broadly speaking, what we’re saying is that credit is extended into markets by the financial sector in a very broad sense. It’s not just banks. It’s also shadow banks that are important.

And really since the growth of innovation, thanks to the rise of investment banks over the last three or four decades, and deregulation, this has become a global phenomenon. And it’s facilitated leverage and the whole range of instruments that are available. So, it’s become a lot more sophisticated. But at the heart, it’s really a flow of money or liquidity into markets.

[00:09:19] Alan

And so, you’re talking about both money and credit. I mean, I suppose like money, at least base money, obviously this can be created by the central banks or excess reserves, which can flow into financial assets. But obviously, banks can also create credit and boost deposits, which is part of the story too.

And I just say it’s non-bank operators as well. Do different types of liquidity have different effects? Or I mean, if the PBOC is increasing liquidity, does that have a different impact than if it’s the Fed or the Swiss National Bank?

[00:09:52] Michael

Yeah, absolutely. I mean, that’s a really important distinction.

What we tend to find is that if you look at what the Federal Reserve does, that tends to influence financial markets much, much more because we’re a dollar-based system. If the PBOC, the People’s Bank of China, acts, that tends to influence the Chinese economy. And because the real economy in China is such a large economic footprint or industrial footprint of the world, that tends to influence the tempo of the world economy and commodity markets much more.

So, I think you’ve got that very clear bifurcation between the two. You’re looking worldwide. Those are the two dominant central banks by far.

The others are sort of bit power players. I mean, they can be important at different times. But certainly, the Fed and the PBOC, you really have got to watch towards them.

[00:10:39] Alan

Okay. But other central banks obviously do kind of directly influence asset markets. Obviously, the BOJ have been buying ETFs and REITs, I think.

And I mean, it’s generally talked about that the S&P has been buying equities as well. So, are they the same kinds of illiquidity injections or would you say that?

[00:10:57] Michael

Yes, absolutely. I mean, most central banks operate in broadly similar ways. There are subtle differences country by country. But broadly, what they’re doing is they’re effectively buying debt. They’re giving the private sector money in return for that. And effectively, what they’re doing is they’re changing the risk profile of assets in the private sector. They’re effectively changing duration for another term.

And assuming that investors have got durational asset allocation targets, that will then cause a reshuffling of assets towards more risk or less risk according to what they’re doing.

[00:11:31] Alan

With all of these economic variables, you always have the stock and the flow. Are both important or is one more? And I mean, I’m thinking particularly from the perspective of the last few years.

Obviously, post-COVID, there was a big liquidity injection, I think it’s fair to say. And then after a couple of years, there’s been a gradual, I guess, liquidity removal or maybe more balance. So, you’ve got two contrasting factors there.

Which is more dominant?

[00:12:00] Michael

Well, I’ve always come from the school of that it’s flows that are more important because markets are priced at the margin. And so, what you need to look at is the flow of new money coming in or leaving, exiting a market. And that really is what makes a big difference. So, we’re very much trying to understand the momentum, if you like, of liquidity through the system.

[00:12:19] Alan

Yeah. Okay. So maybe taking all of that, I mean, to provide a perspective on, you know, we’ve been through, even going as far back as the double financial cycle or financial crisis, we had a recovery, a kind of a sluggish period of economic growth, but a period where asset markets did well. Presumably liquidity was an influence on that.

And then your lens of what happened through kind of the post COVID recovery, was liquidity a key driver of inflation or were other factors more of a contributing factor? Maybe just give us your, I suppose, your perspective on the last 10, 15 years from a liquidity perspective.

[00:13:04] Michael

Okay, so I think what you’ve seen is you’ve seen, out of the sort of the rubble of the 2008, 2009 global financial crisis, you saw central banks trying to stimulate economies. Now, the best time for financial markets tends to be when policymakers are trying to stimulate sluggish economies. I mean, that’s really when you have the best of all worlds.

Money tends to go into financial markets, it lifts asset prices, and then progressively the real economy will begin to pick up. And that’s normally what one sees. So, this phase we’re currently in is probably replicating, in a number of ways, that period in the sort of early 2010s to ‘12 period where you’ve got more liquidity.

Now, the other factor that was going on that we shouldn’t lose sight of is that what was also happening at that time is there was a change in regulations. Banks were becoming more constrained. There was more policing of shadow banks. The US Federal Reserve and the US Treasury tried to get more control of the dollar system.

One of the things that you’ve seen, really, through that period of the early 2010s, maybe from 2010, ‘12 onwards, was a huge inflow of money into US assets. That was partly to do with Basel III.

We’re coming up to a Basel IV prospectively probably next year. But all these things are trying to get banks and insurance companies and financial institutions to hold more safe assets – read US treasuries, because that’s really the high quality or pristine collateral they must hold. That was one of the factors that spurred money to move more decisively into the US.

You also had the Eurozone banking crisis 2010, ‘12, which meant there was an exodus of money out of the Eurozone. And then we started to see the China anti-corruption crackdown by Xi Jinping, which led to a lot of money then leaving China. All that ended up flowing into dollar assets.

And if you look at flows into the dollar, what you’ve seen, over that decade period, is very strong inflows. Now, this is, if you like, a classic liquidity feature, because what really drives asset markets are central banks and capital flows, cross-border flows. I mean, hence, if you like our name, our company name, cross-border capital is really a critical factor.

And what happens in that environment is that as capital comes in, the real exchange rate of an economy should go up. And equally, of course, if capital leaves, you get the reverse, the real exchange rate should go down.

Now, in a modern economy, a real exchange rate is that which you can broadly define as the nominal exchange rate multiplied by some general price index. In a modern economy, high street prices and service prices tend to be quite sticky. So, all the movement tends to be in asset markets.

So, if you want a rising real exchange rate to accommodate increasing capital flow, your nominal currency can go up and/or your asset markets go up. This is what has happened on Wall Street and the US dollar.

This is all about capital flow, (if you like) liquidity going into the US. Equally, money can leave economies. And just think of what’s happened to China over the last few years.

China has been basically seeing an exodus of capital for a whole number of reasons. We would argue that the main reason for that is probably that China has hit the middle-income barrier or whatever, or the middle-income trap. And it can’t really get beyond that.

Therefore, its productivity is compromised. And productivity is a major factor in attracting capital into the economy. On top of that, you’ve got the tensions between America and China, et cetera. But capital is leaving China.

Now, what that means is that China’s real exchange rate has got to go down. Now, if you follow through the logic of what I’ve just said, that means the yuan has to devalue and/or asset prices, or maybe to some extent, high street prices need to go down.

Well, the Chinese have been imparting a significant monetary tightening over the last few years, which has actually held the yuan up. So, all the adjustment in China, to that capital outflow, has come through collapsing asset markets and deflation actually in the high street. And now we’re evidencing it in wages too.

So, these are classic examples of liquidity adjustments in markets that we’ve seen in the last 10 years. Where is China going to stop? It’s going to stop either if, by some act of God, the Chinese yuan starts to appreciate and that act of God may come through the gift of the Federal Reserve deciding it’s going to ease, or you’ve got to see a big printing of money in China (I think it’s going to happen anyway) to start to get the real exchange rate down, which will lift asset markets.

But they’ve been very reluctant to do that, obviously, because they’ve got a goal of keeping up the Renminbi or yuan. And they might argue that if they go down the rabbit hole of more liquidity, that’s going to increase debt, and the Chinese economy is already hugely indebted. So, China has big problems, no question.

00:18:21] Alan

Okay. And in terms of the moves we’ve seen in bond yields over the course of that whole period, obviously, we’ve had a multi-decade decline in yields that seem to end in 2020 with US yields bottoming out around maybe half percent or so and have risen since then. So, it’s kind of easy to kind of paint a story around liquidity injections, QE, pushing up bond prices and yields down.

Obviously, since then, we’ve had this trend higher in yields, obviously, up until last year. I mean, is that a liquidity phenomenon or more of a real economy phenomenon?

[00:19:01] Michael

Well, I think it’s, I would argue, it’s largely to do with liquidity. I mean, one of the things that, or maybe the key thing that I learned from my days at Salomon Brothers was trying to understand the yield curve. The yield curve was something that had been originally deployed at Salomon Brothers.

It was a key part of their arbitrage trading, Marty Leibowitz was really the architect of our whole thinking back in the 1970s. And what we found was that actually flows of liquidity into markets caused the yield curve to steepen and flows of money out of markets caused the yield curve to flatten. So, it’s a question of monitoring very closely those flows.

Now, the lead times you get are about six to nine months. So, in other words, if a central bank is easing, what you’d expect is that the yield curve should steep.

What if the transmission mechanism of that is basically term premia? So, what you find (and that tends to be a bulk, or bulk of changes in the slope of the curve) is the term premia tends to rise. Now, the term premia is a wonkish concept for an awful lot of people, but it basically is the extra or the premium you require above the running yield of a bond, basically to compensate for interest rate uncertainty in the future.

Now, what you tend to find is that that term premia, think of it as a risk premia, will tend to rise if you’ve got more liquidity going into a market. Reason why is that there’s far less risk of systemic risk in a highly liquid market. And therefore, why should you own safe asset bonds?

So, investors shuffle out of the bond market and move into higher risk assets like corporate debt or equities, and that causes the term premia to rise. So, you see this movement in the yield curve, which follows the movement in the liquidity cycle. And then some months after the shift in the yield curve, you might well see the economy beginning to respond.

Now, that’s the normal mechanism. That’s what we’ve seen this cycle. We see it in every economy.

What you’re seeing is the beginnings of the yield curves beginning to steepen. You’ve seen the liquidity cycle right across the world begin to inflect higher. So, it’s all perfectly consistent.

But one thing that is unusual, right now, is that you’ve also got the backdrop where governments have got to issue a huge amount of coupon debt. And that coupon debt extends, well, it extends for the private sector and the public sector is what I’m trying to say. So, it’s a general increase in debt.

But if you’re increasing debt (the supply of debt), that’s also going to affect term premia as well. Now, one of the ways that that has been, if you like, negotiated recently in the US is that there has been a very significant change in the funding dynamics in the US market. And one of the arguments we’ve put forward, over the last couple of years, is that Janet Yellen, maybe in cooperation with Jay Powell, is undertaking a deliberate and active duration management of the US calendar.

In other words, what they’re basically doing is they’re starting to shift issuance towards shorter dated tenors. And they’re also using a lot more bill finance. And that’s actually suppressing yields at the longer end of the market.

So that’s also a factor which is forcing term premia lower. Now, what we’re seeing is a number of factors that are pushing term premia up. But you’ve got a battle here going on. And ultimately, rising term premia are going to win out.

So, this is the backdrop. And therefore, yield curves are going to steepen. And you’re looking, prospectively, at a high yield base.

Now, that is an unattractive prospect for governments everywhere, because they’ve got huge amounts of debt to sell. And they want to do that at as low an interest rate as possible, because otherwise their interest bill is going to start to escalate.

And we saw, recently, the episode of the Japanese sort of being caught in the headlights here of saying, well, OK, we’re tightening monetary policy. But hang on a second. They simply can’t.

The more they tighten, the more they’re going to increase their interest bill. And by the law of compound interest – their compound growth, their debt just skyrockets.

[00:23:10] Alan

Interesting. So, you touched on this picture with US fixed income markets, with the Treasury kind of shifting its issuance. And I mean, there has been some suggestion that this has kind of blunted the impact of quantitative tightening, which is the opposite force. I mean, policymakers now would have you believe that QE is kind of something of a miracle policy in the sense that when you need it, you can enact it, and it can positively impact the economy and markets.

But when you go to withdraw it, you can withdraw it without any cost or any kind of notable impact on the markets. And obviously, when they tried to do QT in 2019, we had some disruptions. But this time around, we haven’t had that.

I mean, how do you see that? Have you been surprised that we haven’t seen more kind of capital markets disruptions during the QT phase? Or is that because we’ve seen offsetting factors such as the changed pattern of issuance?

[00:24:05] Michael

Well, I think there are two things, I think, to say here. The first thing to say is the only economy that really engaged a major QT, I would argue, is China. We’ve seen the consequences of that. That’s having a disruptive effect on Chinese financial markets.

In other words, ask why bond yields are collapsing in China, where you’ve got deflation, and maybe why the world economy, overall, is pretty sluggish. And then if you start to look back at the West or the other advanced economies, you find that, actually, QT effectively ended probably 18 months ago. What we’ve been seeing now is sort of the rhetoric of QT. That’s in the headlines. That’s what the Fed wants us to believe. There’s been no QT in the US for over 18 months.

They’ve been pushing liquidity into markets. But one of the things that we talk about is a concept called Fed liquidity, which originated back in my days at Salomon Brothers. It’s how the team at Salomon Brothers would actually look at the Federal Reserve.

But if you look at calculations of Fed liquidity, which is the active liquidity creating part of their operations on the balance sheet, you find that’s been rising. Now, I’d like it to rise more, but it very clearly has been rising. So, you’ve seen this expansion of liquidity.

Now, that’s why financial markets have been elevated, because this liquidity has been going in. Bank of Japan very clearly has been doing that unambiguously. But I think you’ve got to come back and say, why is this going on? And are we in a different world?

I think we are a different world. I think the reason that liquidity has become a factor in people’s analyses, principally since the COVID crisis, or certainly if you extend back since the GFC, is these are major debt crises, what they really signal is trend changes in the rate of debt growth.

So, we start to see debt escalating. Debt is the bogey. Debt is the big issue.

I’m not a fan of debt. I’ve got to accept the fact that if there’s debt in the world economy, you need liquidity. But the reason being is that debt needs to be refinanced.

Now, one of the things a lot of investors, and particularly equity investors, don’t get is that if you have come from a fixed income perspective, you understand that debt is a finite instrument, and it needs to be refinanced. And you’ve got $350 trillion of debt in the world economy with an average maturity of five years, which tells us you need to refinance $70 trillion of debt every year just to stand still.

Now, that’s aside from the fact that the debt pile is growing. In order to refinance, you need balance sheet capacity. And that’s what we think of as liquidity.

Who controls that? It’s basically controlled by the central banks, and it’s controlled by the availability of collateral in the system. And it’s that interplay which is really important to understand.

Now, if you don’t get the liquidity, you cannot refinance the debt, and you get a debt refinancing crisis. I would argue, maybe it’s an extreme argument, but I would say every financial crisis in the last two to three decades has fundamentally been a refinancing crisis. And central banks have been forced to come back in to provide liquidity so debts can be refinanced again, they can be rolled over.

And that’s really the critical thing to understand. So, we’re in a very different world. And in that world, a lot of things are topsy-turvy.

So, for example, think of interest rates. If you’ve got a government which is indebted and is basically paying a large interest bill, which they’re basically monetizing or just creating more debt with, rising interest rates are actually income transfer. So it may be that rising interest rates have a perverse effect.

Rick Ryder of BlackRock has made that point repeatedly. Very, very compelling argument. So that’s one thing.

Another thing to say is that you’ve got a very different cycle in economies, because basically the economy is attuned to the debt refinancing cycle. Historically, we’re told, if we pick up an economics textbook, that the cycle is driven by the capital spending cycle. So, in other words, it’s capital spending that drives the economy through some sort of Keynesian multiplier process, and that may be a nine to 10 year cycle.

Well, fine. That’s what happened. But capital markets are not new capital raising mechanisms anymore. They’re actually debt refinancing systems. And it’s something like $3 in every $4 transacted in financial markets today is a debt refinancing transaction. This is how the world has changed.

In that environment, where we’re dominated by financial markets, they’re driving the economy and they’re forcing the economy to adopt a five to six year cycle. So, a lot of things seem to be perverse. Capital flows drive trade balances, not the other way around.

So, economics has gone topsy turvy in this world where debt has become a paramount factor. And that’s really what we’re saying. Now, if you extend on these arguments, then you’ve got to start to say, well, okay, if we start to look at debt and we find debt is problematic, how much is debt going to increase in the future?

When you start to look at data that comes out of the Congressional Budget Office in the US, and the great advantage of looking at the US is that it’s completely transparent, the CTO does wonderful calculations far into the future. So, we know what the arithmetic looks like.

And on their calculations, it looks like the public debt to GDP ratio in America is going to double over the next 25 years. Now, what is that telling you? It’s telling you that public debt growth is going to be growing at twice the clip of GDP in the economy.

So, if you said, well, okay, let’s say that the real economy in normal terms grows at 5% to 6% per annum, I think most people would accept somewhere around those figures without thinking about a split, but 5% to 6% nominal, then debt is going to grow at twice that. So, it’s 10% to 12%. Now, if you need liquidity to refinance the debt, lo and behold, global liquidity is going to expand at a similar 10% to 12%.

Now, that is monetary inflation. And investors need to think about this because this is a new world. The GFC increased debt, COVID amplified that dramatically, and the aging demographics, a rising defense bill, mean that government debt is going to increase significantly.

And these are the sort of parameters we’re looking at as a background to investing. So, if you’ve got 10% to 12% monetary inflation going on year after year after year, asset allocators have got to start thinking about monetary inflation hedges. And what we keep arguing is that the one that’s actually proven itself over centuries is gold.

What has proven itself over the last five years is Bitcoin. Now, I’m not saying whether there is any merit or demerit in Bitcoin. I’m not an expert.

But what I’d say is it has proved a wonderful hedge against monetary inflation. And if you’re going to get more monetary inflation, these assets are going to go up in price. And let me just say one further thing before I stop here, is that many people argue that gold is an inflation hedge.

It’s not an inflation hedge. It’s not a high street inflation hedge at least. So, for example, you would expect if US inflation, as it’s done in the last couple of months, is attenuating, is slowing down, then the gold market should fall away.

But that’s not the point. Gold is not a high street inflation hedge. It’s a monetary inflation hedge. And that’s a fundamentally different thing.

High street and monetary inflation are not the same. Monetary inflation goes into high street inflation, but high street inflation is a hybrid or cocktail that also needs things like taxes, or costs, or productivity, gains, oil prices, all these different things which go into the mix. Monetary factors is only one of those.

Monetary inflation will outpace high street inflation for sure. But gold is a great hedge against that.

So, if you think that we’re going to see these types of increases over the next 25 years, just looking at compound interest, growing at that level means that the stock of liquidity is going to expand by about tenfold between now and 2050, which means the gold price, if it keeps pace pari-passu, is going to go up 10 times as well. So, you’re looking at $25,000 an ounce.

[00:32:41] Alan

So that’s your base case?

[00:32:42] Michael

Yeah.

[00:32:43] Alan

Okay. I mean, it’s a pretty grim picture you paint. I mean, at some point along the way…

[00:32:50] Michael

Not if you’re a gold miner.

[00:32:51] Alan

Not if you’re a gold miner. Yeah, that’s true. I mean, if you’re a macro policymaker, it sounds pretty negative if debt is growing at 10% per annum. I mean, is there a point where the market’s balk; one, the market’s balk, or two, that debt gets so great that the debt repayment becomes too great a percentage of the income generating capacity of the global economy and that forces a deleveraging, which we’ve kind of seen in long-term debt cycles. That’s the typical dynamic. Or else, if asset prices fall, that forces a deleveraging. I mean, are there types of scenarios that you see in the coming years as part of all of this?

[00:33:34] Michael

Well, I think it’s, in many ways, it’s an attractive option to find some way of getting debt down, as far as I can see it. But then the arithmetic works. We’re in a society worldwide where populations are aging in a way that they’d never aged before, as rapidly.

And we’ve got, on top of it, we’ve got commitments for welfare state spending, Medicare; Social Security in the US, et cetera. And we’ve got a rising defense bill. So, all those factors are causing spending to go up. Now, if you look at the US, outlays of the federal government are taking up the vast bulk of the budget.

Way more than 80% of outlays now are mandatory spending. So, there’s very little way of actually stopping that, unless you renege on the commitments that have been made. Now, that’s clearly possible, or you find some way of euthanizing everybody.

I mean, I’m not on track to prostrate, but there again, these are the things that one’s got to think about. And what’s the other alternative is you inflate away the debt.

Now, you don’t need to create high street inflation. All you need to do is create monetary inflation. And that’s really what central banks or the system has been doing. The problem with that is you then create social tensions, because by doing that, you’re increasing wealth for asset holders, and your wage earnings are losing out on the wealth stakes in that environment.

So, what you’re creating is maybe not an industrial proletariat, to go back to what the socialists would have said in the 19th century, but a financial proletariat. And that’s the distinction. I mean, you can bury that to some extent, but at some stage, it starts to come out.

And a lot of the tensions we’re seeing probably in the UK, right now as we speak, are sort of echoing some of those thoughts. Central banks are really, in many ways, the culprits. I mean, they didn’t have any choice, one’s got to say, but this is the reality.

So, I don’t see how you get out of it. And I think the other thing to say, a lot of economists say, well, this is unsustainable. But it isn’t, because look at Britain in the 1950s, and look at Japan over the last two years.

They’ve managed to create much, much higher debt-to-GDP ratios than America or the world is looking at now. It’s been sustainable. Governments can always sell debt.

The question is, what type of debt at what price? And I would argue it’s going to be shorter-dated debt, maybe at high yields, but that’s monetization. And therefore, we’ve got to protect ourselves against that prospect.

[00:36:09] Alan

And I mean, obviously, if you keep selling short-term debt at higher yields, you get this, obviously, your interest costs rise. So, the interest costs as a percentage of government expenditure is progressively rising. And also, you have the dynamic where the Treasury is no longer getting a check every month from the central bank, which is obviously something we’ve seen in the UK. It can be problematic from a fiscal expenditure perspective as well, obviously, in the US to get around that in terms of a deferred asset or deferred liability, whatever it’s called.

But I mean, all of those things tend to be problematic. I suppose the point is that bond yields in the last six months have fallen. And so, markets clearly aren’t overly concerned at the moment, but presumably, we’ll get to a point at some point in the next one, two, three years where this all comes to a head and prompts action on the part of the fiscal authorities or not.

You don’t see that type of scenario?

[00: 7:06] Michael

Well, I think it is, but I would argue that if you look at the recent period, what you’ve had is a very clever switch in the tenor or the average maturity of the calendar in the US. So, the average maturity of debt that’s been sold by the US Treasury has dropped by about a year on our calculations, maybe over the last 18 months. So that’s quite a significant drop.

And you’ve had a big increase in Treasury bill issuance. So, there’s actually been a scarcity, if that’s the right way of putting it, of longer dated debt available to the market. And the market needs to buy.

There are institutions that need that long term debt. So, I think there has been manipulation. And one of the arguments we put forward before is to say, one of the easiest ways to see that manipulation is either to look at the record low levels of the term premium in the bond markets, or what you can look at is look at the spread between US agency mortgages and 10-year bonds.

Now, an agency mortgage is a risk-free asset. Admittedly, it’s got different duration and complexity attributes to the Treasury. But if you make those simple adjustments to try and make a Treasury equivalent, what you find is that the agency market is trading at yields well, well above what you’d expect looking at the 10-year.

And that would suggest there’s manipulation going on. And the same thing happened in 2008 during the financial crisis.

[00:38:34] Alan

What do you think the strategy is there? Is it to delay? I mean, would you expect that with lower 10-year yields now that we’ll see more issuance at the longer end?

Is it basically a tactical play in response to the level of yields?

[00:38:47] Michael

I think it’s a tactical play. And I think the fact is that what we’re going to see over time, my hunch would be there’s going to be a lot more bill issuance going on. So, I mean, there’s been this sort of a tacit rule that the Treasury tends to do 80% coupon around 20% bills.

And I think that bill percentage is going to go up. Now, whether it’s bills or whether it’s short-dated Treasuries is not really the point. The main thing is that the Treasury is funding at shorter maturities.

And the question asked is who buys shorter maturities? It tends to be credit providers because that matches their liabilities. And if credit providers rather than the non-bank private sector buys government debt, that is monetization.

Milton Friedman would be turning in his grave at what’s going on.

[00:39:31] Alan

Okay, because it’s basically official sector buying the debt of the government. Is that it?

[00:39:38] Michael

Yeah, I mean, the bank’s balance sheets are expanding. I mean, that’s what’s going on. They’re buying the debt. Whereas if you looked if the non-bank private sector bought the debt, bank’s balance sheet wouldn’t expand.

[00:39:51] Alan

So, what does that mean? I mean, again, from an asset allocation perspective, I guess that’s consistent with the inflationary perspective and the kind of positive picture you paint for gold. Presumably, financial assets do all right in this type of scenario if we’re talking about monetary inflation.

Is that right?

[00:40:11] Michael

Well, I think they should do. I think that’s absolutely right. I mean, the way the financial assets don’t do well is if you get a refinancing crisis, but assuming that there’s sufficient liquidity to prevent that, then financial assets should do pretty well. I’d exclude longer dated debt on that because they won’t, but you want to be in short, dated debt.

Definitely want to be in things like TIPS. If you can get 2% or anything more than 2% on TIPS (government treasury inflation protected security), anything more than 2% is a steal because financial assets don’t give real returns of that magnitude long term. So, you’re getting that with inflation as well. It’s a great, great deal. So, look at TIPS.

I think you’ve got to look at equities, good quality equities. Companies that have a pricing power definitely will do well during this environment. I think you’ve got to have gold commodities in that, and you may want to put some spice in there and include cryptocurrencies such as Bitcoin.

But the 60/40 model no longer works because in a higher inflation environment, you tend to find that bonds and equity prices tend to be positively correlated, not negatively correlated.

[00:41:20] Alan

And just to be clear, I mean, do you see it translating into a higher wholesale price inflation environment as well as a monetary inflation? I mean, because we had this debate in the 2010s, would the monetary inflation lead to it?

[00:41:30] Michael

I think you will. I mean, basically you can’t change the maths of this is that high street inflation is a cocktail that includes monetary inflation and productivity gains. Now, if you’ve got slow productivity, your high street inflation is going to be much more like your marginal inflation.

And one of the factors that we’ve seen over the last 20 years is that marginal inflation may well have been quite strong, but high street inflation hasn’t been because you’ve had these huge productivity gains from technology and from Chinese costs, and actually since 2008 lower oil prices too. So yeah, these factors have had positive effects in terms of reducing high street inflation. They may not be down in the future.

So monetary and high street inflation may converge rather more. Now, if you look at the short-term environment, my view would be is you’ve got to try and differentiate trend from cycle.

I think the trend is towards a more embedded and higher rate of high street inflation. But I think cyclically we’re in a downswing still. And that downswing is largely because the Chinese economy is slowing down so much. And that’s courtesy of the fact that the previous, or the last 12 months, 18 months, have seen a dangerously tight monetary policy from China.

[00:42:47] Alan

Maybe just to talk, I mean, you talked about China earlier on and the need for a kind of a realignment of the yuan. And I saw in a recent piece that you wrote speculating on a possible secret deal that may have been struck to stabilize the yen and then turn the yuan. I mean, is that speculation or is that a core part of your thinking that that may have been part of the reason behind the dollar/yen reversal?

[00:43:15] Michael

Well, it’s pure speculation because I really don’t know. And there’s always a pushback because, you know, clients say, well, OK, you know, we fully accept the fact that, you know, back in the 1980s, there were things like the Plaza Accord and the Louvre Accord. But you were looking at much more powerful and, you know, more intelligent, they would say, policymakers such as James Baker or whatever, who were pulling the strings then.

And the current crowd are absolutely useless and have got no ability to do this sort of thing. I kind of question that, I think there’s been some quite clever policy moves of late. And I certainly wouldn’t discount this fact.

And the logic really goes as follows, that if you go back to early 2022, and let’s acknowledge the fact that this was pretty much commensurate with Russia’s invasion of Ukraine, the Japanese yen started to go into free fall.

Now, in all my years in financial markets, which mount up, you know, as we speak, I’ve never seen a major G7 currency fall with the speed the Japanese yen fell at. Markets don’t do that to currencies, governments do.

And that struck me that this was an engineered deal. And I think it was basically trying to put pressure on the Chinese financial system. And indeed, because the Chinese yuan weakened, the Chinese responded to that because they were operating in a regime that has been generally called the Shanghai Accord, which goes back to a G20 meeting in 2016, where Asian governments agreed to stabilize their currencies against what was then a strong dollar. But they did that through basically tightening monetary policy. And what China was forced to do was to basically tighten quite significantly. And that’s what caused a lot of the problems that China is now facing. And it meant the Chinese economy could not emerge from the COVID crisis.

Now, roll on two years, what you’ve seen is recently the yen start to rally. Now, that may be, of course, you know, speculators covering their positions and feeling that the Japanese were about to tighten monetary policy, et cetera, et cetera. It could equally be that there was a deal struck that said, enough is enough. We’ve achieved what we want.

The Chinese have basically agreed something. We don’t know what. That might be a deal on treasuries. It may be a deal to do with supporting Russia. You know, who knows what that may be.

But it basically means that the dollar now should begin to weaken. And it’s not the fact that Japan is tightening or China is tightening, because those economies have got absolutely no capacity to tighten at all, given their debt burdens.

They simply can’t do that. The US has got a lot of ability to ease. And this is like, I would argue, the 1985 Plaza Accord period, where the dollar was strong. Similarly, because of a very tight money and loose fiscal policy, the dollar was needed to be brought down. And it was brought down through that accord largely through the US easing monetary policy.

That caused a huge rally in global liquidity. It was a fact that led up to strong asset markets right through ‘87. And then you’ve got the Louvre Accord to actually reverse what was then a plunging dollar, which was really the precursor to the ‘87 crash.

I think there are parallels going on. And I think what’s happened and what we should be looking at is we should be seeing whether the dollar is starting to inflect right now. I would argue, I think it is. I don’t think it’s going to be a big inflection, but I think there’s a lot of factors underpinning the dollar in the medium term. But notwithstanding the fact we can see an inflection.

[00:46:52] Alan

And I mean, would we not expect to hear the administration make some noises about that the US? Obviously, Trump has a particular view on the dollar, but Biden, Yellen, it’s been very much a kind of a hands-off view with respect to the dollar. If there was some kind of deal, would you not expect to hear some nudges that that’s what they were doing, or they have a preference for it?

[00:47:14] Michael

I’m not sure, because I mean, there’s generally a sort of rule that you don’t talk about those currencies. But I think it’s interesting, to note as well in that same vein, that despite the collapse in the Japanese yen, there were no voices from the US Treasury saying this is unfair trade competition. Whereas 18 months ago, they basically stood out and shouted down the Vietnamese for devaluing the dollar.

And Japan is a lot more important than Vietnam in US trade figures. So, I think that I would argue there’s no smoke without fire here. So maybe it’s something to watch.

Maybe we could be completely wrong. This is just purely coincidental. But I would be looking pretty closely at the dollar now and seeing what it does in the next few months. I think it may be a top. I think that’s important.

[00: 8:03] Alan

Yeah, for sure. And I mean, in terms of the move up, the preceding move in dollar/yen, I mean, so much is written about carry trades and obviously, I guess, which are capital flows. So presumably, you have a strong perspective on this.

You know, different hundreds of billions and trillions been bandied about as possible size of the carry trade. But obviously, very hard to get a sense on that. And obviously, multiple players trading dollar/yen in terms of capital flows, whether they’re hedged or not. And then exporters and importers hedging dynamics there.

I mean, how do you get your hands around, you know, something like that to try and infer about what is actual capital flows and what’s kind of hedging activity?

[00:48:46] Michael

Well, you know, all our estimates would suggest that carry trade is about maybe 500, 600 billion dollars or that sort of magnitude. Some of it’s been closed already in the last two weeks. There’s still some around.

Some of it is actually maybe kind of going on again, for all we know. But it’s that sort of magnitude. You know, in the context of global liquidity, which is, you know, 175 trillion dollars, it’s not that big.

So, I think you’ve got to put that in context. I mean, it’s not to say it’s not important in certain areas. So, it was clearly important in the Nikkei on one Monday, and it was pretty important for the Mexican peso and the Brazilian real. But, you know, generally speaking, it creates volatility.

I don’t think it’s anything about liquidity declining. In actual fact, as I argue, it may well actually be a source of new liquidity if it’s a reflection of the fact that there’s been this tacit deal done on currencies, because it will mean that the Fed is going to have to start injecting more cash over the next few weeks and months.

[00:49:46] Alan

And I mean, currencies, I mean, you talk about currencies, back in the 1980s, where we saw, obviously, the big moves prior to and post the Plaza Accord. And we’ve had a huge move up, as you say, in dollar/yen, and across some of the other G10 pairs, like the euro, things have been remarkably stable, particularly in the last, say, 12 months or so. What’s going on there?

I mean, are the capital flows perfectly balanced or are you seeing anything noteworthy in terms of the low level of volatility in probably the biggest currency pair out there?

[00:50:24] Michael

Well, I think that, generally speaking, if you look at the eurozone, it seems to be largely matching US policy. So, I think from that perspective, and the economies, for that matter, are more in sync. So, you’d expect, or put it another way, you would not expect the currencies to be moving significantly out of line.

If there was a significant difference in policy, then you might. But yeah, I agree. I mean, they have been remarkably stable, but then I think that has been a policy desire.

Now, if you take that same logic and say, well, hang on, why didn’t that happen in Japan then? So there seems to be something else mysteriously going on in Japan, you know, to cause these huge, huge swings. And that’s what I would say is that, you know, in my experience, I’ve never seen a move as dramatic of that as that in a G7 currency.

[00:51:19] Alan

One of the other things, I mean, just coming back to the kind of the whole point about refinancing. There was a lot of debt issued around COVID time, 2019, when rates were very low, and particularly, you know, a lot of refinancing done at that stage in terms of commercial real estate and corporate debt as well. So many accommodators, pointing to this coming period, kind of 2024, 2025, 2026, with a lot of five, six, seven-year debt, that are either being refinanced or have kind of trigger payments.

Is that a kind of a risk point on your radar in terms of refinancing? Or is it just the ongoing $70 trillion per annum that you see as the bigger issue?

[00:52:05] Michael

No, it clearly is a risk point because you’ve got this bunching. And so, there’s got to be a lot more accommodation, in theory, of that debt role in two or three years time, or maybe one or two years. So, it’s clearly coming up. And that’s one of the factors that, you know, we’ve got to watch carefully for.

[00:52:26] Alan

And obviously, in the last number of years, one of the other dynamics has been this shift towards greater financing from private credit. So, I guess that’s all part of the shadow banking system. I mean, what’s your take on the implications of that?

You know, on the one hand, people would say, well, if you have, you know, if debts go sour, you’re not going to have this transmission mechanism into the real economy to the same extent that you have with the banking system, with the way the banking system delevered in 2008. Does that make it more sustainable or not? Or are there other unique factors with the growth of private credit?

[00:53:03] Michael

Well, I think, you know, you raise a very interesting point. I’m not sure I’ve got the answer. I’m not sure on whether I could give the answer.

But what I would say is that, you know, on the face of it, you would argue if you’re getting specialist lenders who are basically sourcing funding from the same sources as banks, or maybe they’re getting their funding from bank deposits indirectly, those specialist lenders, if they are good at their game, should actually reduce risk in the system rather than increase risk. I think the problem is, A, we don’t know the extent of whether there is a leverage in that part of the market. And that’s really something for the regulators to tackle.

You know, very clearly, leverage is a bad thing in this case. So, let’s make no bones about it. And the other factor is that, you know, are these models robust in terms of the models that are used to actually assess credit?

Now, from what I’ve seen, a lot of firms are doing very much the same sort of thing. So they’re using statistical modeling techniques, some cases AI, to try and assess credit risk. Now, the great problem with many of these models, as I’m sure you would also agree, is they haven’t really been stress tested through a period of major credit tensions, such as 2008, ‘09. And a lot of the data sets that people are using are actually very, very recent data sets that their models may well look pretty good then. But if you get a shock and everything correlates together, then you’re going to have some big problems. And that is something which is important to factor in because, you know, banks are supported by governments.

They’ve got a government guarantee. But some of these private credit firms have not. So that clearly could create problems in the financial system. There’s no question about that. But that’s really a question much more for the regulators, I would argue. I mean, I’m not qualified to answer that.

[00:55:04] Alan

Just conscious of time, take it all back, maybe, to the current period again. And obviously, we’ve had this wobble in markets. We’ve had the somewhat of an unwind of the carry trade.

And I know your view is obviously, liquidity continues to expand. There’s potential additional boost from liquidity if we’re into a weaker dollar cycle. So, it sounds like a pretty favorable environment for risk assets, kind of for the foreseeable future.

Is that fair to say?

[00:55:29] Michael

I think it is. It is very fair to say. And I think that’s right. I mean, I think one would have to be, you know, prudent here and say that, you know, we’ve already had pretty decent gains from the lows of the liquidity cycle in late 2022. Markets have rallied quite a lot.

I mean, they’re unfolding in the way that they normally unfold in a bull market. Technology stocks have led, cyclicals have been, you know, definitely evolved. Defensives aren’t performed. You’re starting to see, you know, things like big financials and maybe some commodity, some of the blue chip commodity producers starting to perform now, pretty much as you’d expect.

So, all these things are sort of falling into place. But these are sort of mid to later cycle areas. So I think we’ve got to understand that the market is maturing. And in the mature phase of the market, gains are obviously less. I do believe that risk assets will go up.

I think that if you look at the medium term, you definitely want monetary inflation hedges. But I think, you know, in terms of understanding the markets, I think one needs to understand that global liquidity is the paramount factor.

The global liquidity rests on a collateral base. So lending is very much collateral. It involves collateral.

So, you know, as I say to, you know, our clients that they want to sort of quick and dirty view of really what’s happening. The three most important things to watch, you know, are things like the Federal Reserve, the People’s Bank of China, and factors like the move index of bond market volatility.

And the reason for looking at the move index is that the move index is a reflection of volatility in the U.S. Treasury market. A lot of collateral is U.S. Treasury based. And if you get a high level of the move, high bond volatility, the haircuts that credit providers will give you on or apply to your collateral will go up. And that will affect adversely what we call the collateral multiplier. It will mean that global liquidity comes down.

So, if we’re in a world of lowish and falling bond volatility and expanding central bank liquidity, then this is a great environment for rising global liquidity. And assuming that investors will take a bit more risk exposure, yeah, prices will go up. But I think it’s, you know, you’ve got to come back to the fact that understanding the collateral markets is really saying, number one, you’ve got to understand this whole refinancing process.

And in terms of looking at the central bank to the dollar, you’ve got to understand the recycling process of the U.S. dollar. And, you know, we’ve written a lot about how China fits into that equation and sort of the great paradox and the great source of instability in the world economy is China. And the irony in many cases is that if the Chinese trade surplus goes up, the dollar goes up.

But that’s not what economic textbooks should tell you. But that’s how it works. Because basically, China is demonizing still a lot of trade, either directly or indirectly in US dollars. So, the normal price signals don’t work. So, you know, I’ll come quietly and accept people saying, well, OK, they’re denominating a lot more trading yuan. Sure.

But the holders of those yuan are converting them speedily back into dollars. So, the idea was that you’re still looking at a dollarized system. And the more that the Chinese use non-US banks to recycle their funds, the less efficient it will be and the lower the elasticity of dollar supply, which underpins, in the medium term, a rising dollar. Which is why I think that the dollar may well inflect lower if the Fed eases, but it’s not going to collapse.

And these things of understanding the recycling mechanisms and understanding the refinancing of debt are really critical things for investment managers to start thinking about.

[00:59:15] Alan

I mean, there’s a lot been said and written about that, kind of the Chinese use of the dollar, and is that waning? And obviously, their stated goal is, I would have said, to be less dollar dependent. But it sounds like you’re skeptical that they’ve made much progress on that.

Is that fair to say?

[00:59:38] Michael

Well, I think they’ve made progress on it. But I mean, in terms of redenomination, they can do that. But the question is, who wants to hold the Chinese currency? And, you know, it’s very, very difficult to see the Chinese yuan becoming an international standard of value when you’ve got capital controls. And you’ve got question marks over its long-term value and actually, you know, the whole legal framework surrounding the yuan. And I think the simple question to ask is, if China eliminated capital controls today, what direction would the yuan be going? Would it go up or down?

I think it would go down a lot. Hey, that’s just me.

[01:00:13] Alan

And I mean, looking further out, obviously, you paint a favorable picture in terms of risk assets and the liquidity cycle. I mean, based on your kind of longer-term picture, you know, that that cycle would run into 2025, I think.

So how does the cycle ultimately turn down? And what would be the signposts to point to a turn in the liquidity cycle at some point in the future?

[01:00:36] Michael

Well, I think we’ll get a turn down. I mean, our original sort of schema was to say that the cycle bottomed in late ‘22 or peak in late ‘25. That’s a normal cycle. It seems to be sort of pretty much treading that path right now.

So, there’s still quite a lot further to go. Although, as I cautioned again, I mean, markets have a lot of their gains already, maybe two thirds at least of their gains. So, there’s less to go for.

But, you know, why would it turn down? I think because central banks will try and tighten again by the back end of next year. That may be because economies actually get a lot more impetus, which I would sort of expect.

And it may be that inflation becomes more of an issue. But, you know, the other thing which the cynic in me says is the governments have got to sell debt. And one of the easiest ways to sell debt is to get people out of equities and risk assets.

So maybe there’s, you know, maybe we’ve got to start thinking about that. But there’s clearly a cycle. And that’s the thing to start thinking about as we move into 2025.

[01:01:36] Alan

Good stuff. Well, a lot to digest there and a lot of things to factor in. But thanks very much for coming on today.

It’s been great to get your perspective on all things global markets and global liquidity. So, make sure to follow Michael’s work, because as you can tell from today’s conversation, it’s a capital flow driven world and as important as ever to stay tuned to global macro development.

So, from all of us here at Top Traders Unplugged, thanks for tuning in. And we’ll be back soon with more content.

[01:02:09] Ending

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