Michael Howell's Insight into the Commodities Renaissance and Market Forces

Embark on a thrilling exploration of the financial world's ebbs and flows with Michael Howell, a luminary in the realm of global liquidity. Prepare to dissect the monumental role liquidity shifts play in the markets, the intriguing monetary dances of central banks, and the subtle maneuvers that have the power to send shockwaves through your personal finances. From the Federal Reserve's ledger balancing acts to China's post-festive resurgence, Howell and I lay out how financial titans' strategic moves ripple through economies and touch the common investor.

As we journey through the intricacies of Japan's influence on global cash flow, the allure of gold in a fluctuating interest rate landscape, and the head-to-head of traditional havens against digital currencies, you'll gain a new appreciation for the delicate balance of international finance. This episode peels back the layers of market sentiments, revealing the surprising resilience of gold, the dance of inflation, and the emerging narrative of a commodities renaissance that echoes the bygone '70s. All this while pondering the potential upheavals that a surge in oil prices could unleash upon an already tense global stage.

Finally, join us as we navigate the often-misunderstood signals of economic health—the yield curve and credit spreads—and their real-world implications on job data and your pocketbook. We tackle the conundrum of a strong US dollar, the shadows of currency manipulation, and the specter of fiscal alliances that could redefine global economic alliances. As we unveil the state of global liquidity and the forces that could pivot the financial markets, our discussion will arm you with insights to understand the waves you surf in the vast ocean of global economics.

The content in this program is for informational purposes only. You should not construe any information or other material as investment, financial, tax, or other advice. The views expressed by the participants are solely their own. A participant may have taken or recommended any investment position discussed, but may close such position or alter its recommendation at any time without notice. Nothing contained in this program constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in any jurisdiction. Please consult your own investment or financial advisor for advice related to all investment decisions.

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Transcript

Speaker 1: 0:00

My name is Michael Guyot, publisher of the Lead Lag Report. This will be a good conversation with Michael Howell, who I've gotten to know for the last couple of years. I've had him on a number of spaces. I'm now trying to switch things up, folks, and do these more visually. So any kind of feedback, by the way, would be appreciated, either as we're live or in the recording which you're going to see up on YouTube and other platforms.

Speaker 1: 0:26

Mike, I'm not going to do the usual thing as far as saying tell us about your background, let's get right into it. You're a man who needs no introduction and I give you a lot of credit because I think you've been really crushing it in the way you've been seeing these big macro moves that have been taking place, because your focus is on liquidity and the reality is the whole world is entirely being driven by liquidity, not by valuation ratios, not by sentiment. It's purely about the pure amount of firepower that's being pushed into the system. So let's get into that, because there was some pretty big changes in liquidity that started to take place October, November, December and it seems like that's starting to filter through into this fear of re-accelerated inflation. What's gone on with the pace at which liquidity has been going into the system and why is it so insane?

Speaker 2: 1:06

Well, I think what you've had is a number of things, and I guess we've got to divide the world up into geographical bits. I think we've got to talk about China and we've got to talk about the US. The US has clearly been or the Federal Reserve has been pushing money into the system. If you look at what's happened to US Bank Reserves, they've clearly headed north over the last year, certainly, but up until maybe a couple of weeks ago they've been accelerating through this year too, and that is really courtesy of what the Federal Reserve stroke Treasury have been doing, of what the Federal Reserve stroke Treasury have been doing, in particular the drawdown of the reverse repo account. This facility that is on the Fed's balance sheet, which has sucked a lot of liquidity out of markets over the last two or three years as a substitute for bills, is now being sort of pushed back into the market. That has added something like about close to $2 trillion in terms of liquidity over the course of the last year or so. So it's been a big, meaningful amount. That may be done for now, who knows, there's about another half trillion in the account that could come down. But effectively the sort of the big firepower is behind us. And now we've got to wait through this month and probably into May as to how significant the taxpaying season is in the US and to what extent the TGA, the Treasury General Account, sucks up more liquidity out of the markets.

Speaker 2: 2:33

So you've got that, I think, on the background. And then we know that Janet is starting to push more coupons of the market. There was a difficult auction a few days ago. There's been a deliberate or there's a deliberate switch going on away from bill finance back towards normal coupons, and that may be a challenge for liquidity too. So a lot of bulls in the air. And then you've got China, which China is struggling to try and keep its exchange rate level pegging with the dollar. It's finding that very tough. It was able through much of last year to throw a lot of liquidity at markets, but lately they've had to draw back. And in the wake of the Lunar New Year in China, the PBOC has actually been running a fairly tight stance, and I think that's really currency concerns. So all these trips that Janet is making to China and the various summits that are mooted, maybe they're going to be significant.

Speaker 1: 3:30

How planned are these liquidity surges? Because if you're going to be conspiratorial, everyone's going to say, well, liquidity is coming in because it's an election year.

Speaker 2: 3:40

Yeah, and I think that's a very good point. I mean, in my experience, janet is the most political treasury secretary we've seen in the US for a long, long time. I think you've got to underscore that with the fact that she used to sit in the Federal Reserve, so she knows that institution, the Federal Reserve and the Treasury are working far more closely together than I've ever seen. And I think these things whether you call that political or whatever, I don't know and I think these things whether you call that political or whatever, I don't know but I think clearly that's an important consideration in an election year.

Speaker 2: 4:10

The moves that have been made in the last two years have been pretty subtle and actually quite clever in terms of some of the policy levers that have been used or maybe even invented, and I'm talking here about the switch in the maturity mix of funding for the government.

Speaker 2: 4:29

In other words, it used to be the rule of thumb is that the treasury, when it needs to fund funds, 80% in coupons, in other words, bonds with maturity that pay a coupon, anything beyond a one-year horizon versus bills at 20%. Janet switched that around over the last six months, so it's not quite 80-20 the other way, but it's pretty close. So coupons have come right down and the Treasury is slated to move back to the norm of 80-20 coupon bills over coming quarters. That makes a difference. It makes a difference because the main buyers of shorter-dated government securities are the credit providers, the banks. If the banks start to absorb more short-dated government debt, that's pure monetization. Pure monetization is a way of getting more liquidity into the system. Bank balance sheets expand and that is clearly a very good backdrop for the street markets like liquidity. It's as simple as that.

Speaker 1: 5:29

All right, so help me through the mechanics of this. Okay, so liquidity is getting pushed into the system. I thought liquidity was supposed to go everywhere, but when we look at asset markets, for the most part it's still largely going to just large cap stock market averages. If you're talking about just investable assets, maybe gold is now becoming a beneficiary. We'll talk about that too. But what is that transmission mechanism? How is it that liquidity actually finds itself into, if that's the theory, into the stock market?

Speaker 2: 5:56

Well, I think there's. I mean, the short answer is that I suppose that you can ask 10 people to get 11 for an answer as to how this thing works. I suppose that you can ask 10 people to get 11 for answers to how this thing works. But my rationale would be is that if you take, for example, what the Federal Reserve is doing, the Federal Reserve is basically in charge of or controls systemic risk within the system, and the more liquidity that is in the US financial markets, the lower the chance of any systemic risk. In other words, that people could always get liquidity. Liquidity is important for changing asset positions or making transactions. If liquidity is readily available, then there's less chance of a catastrophic event. I mean effectively.

Speaker 2: 6:39

One of the points that we've been making over the years is that there's been a transformation of financial markets in terms of their character. If you pick up a textbook, a textbook would tell you that financial markets are there to raise new capital. In other words, they're new capital financing vehicles. In actual fact, that's no longer really the case. There's not a huge amount of capital spending going on relative to what we were used to in the last few decades. Certainly, with a service-oriented economy, there's no need for big chemical plants or big transportation hubs or whatever.

Speaker 2: 7:15

So what you've got, effectively, is a change in the character of markets towards refinancing this huge debt load. We've got $350 trillion of debt out there With an average maturity of five years. That means 70 trillion of debt has to be rolled over every year. You need balance sheet capacity to do that and that's really liquidity. So if you don't get that liquidity, if the Federal Reserve is not there providing it or overseeing the system, you'll get a refinancing crisis and bang. Every financial crisis in the last two decades, in my view, has been a refinancing crisis and bang. Every financial crisis in the last two decades, in my view, has been a refinancing problem.

Speaker 1: 7:48

Which, by the way, whenever I talk about that refinancing risk, I always give you credit because I'd never thought of it in that way until we actually first did a conversation a while back. But I think that's spot on Now. How much of that liquidity gets countered by other central banks? Now you mentioned China. China's trying to put liquidity in. Japan may be trying to take liquidity out, and I think that becomes an interesting dynamic. That's the whole reverse carry trade thesis I've had for several months here. How does Japan factor into liquidity at this point in the cycle?

Speaker 2: 8:19

Well, I think that Japan is important. One's got to say that Japan is not anything like as important as it was in the 1980s, where it was a critical liquidity tap for the world. Japanese institutions provided huge flows. That's now nothing like as big, but Japan's still important. It's still an important economy. The Bank of Japan still matters and clearly there's a carry trade we've got to recognize or acknowledge.

Speaker 2: 8:46

Um, I don't believe the bank of japan is tightening. Uh, I think that, uh, you know all this uh talk about, uh, you know pushing rates back to uh from negative to zero, uh is a lot of smoke and mirrors. Uh ueda said last night that the that he had no intention of raising rates, policy rates to account the weaker yen. Interestingly, the yen, or a positive view on the yen, has been the consensus trade through most of this year. It's been completely. It's gone the other way.

Speaker 2: 9:15

A lot of people have got that remarkably wrong, 180 degrees wrong. My view is that the that has been for two or three years now. Maybe it's a maverick view, I don't know, but my view has been that the yen is a stalking horse to basically undermine the chinese yuan, and the easiest currency cross of the majors to manipulate by governments is the yen dollar cross, and I think they've deliberately pushed the yen down to put pressure on china, and therefore I'm not entirely surprised that janet is spending quite a lot of time now in china or having meetings with the chinese and they're discussing something. Maybe there is a quid pro quo. They're coming to say that the us will agree for the dollar to weaken a bit in exchange for x, y or z.

Speaker 1: 10:01

What those who knows so I think it's an interesting idea, right as far as using the yen against the yuan, but that presumably will have some kind of there's going to be a backfire on that right. I mean, if the concern is that the yen keeps on weakening, if they're trying to deliberately keep that going down. That's in place, sherry, especially when oil keeps on rising, oil denominated in yen. That is a double whammy. They've already got the wage increases. They're raising rates by 10 basis points. We all know Japan has wanted inflation For a long time, but it seems like there's actually this, maybe tail risk that they could see Something almost I don't want to say hyperinflation, but something that really is shocking, which would then Force action on the end.

Speaker 2: 10:42

Yeah, I think there's a risk. There's a lot of gas in the room and they're using a naked flame, so there's a possibility that you could get a major ignition here and inflation just starts to rip. I mean that's a risk. I mean that has been a risk for a while in Japan. But, yeah, we've got to be cognizant of that. One way, with uh, with low inflation, um, and it's actually it's even proving. I mean, apart from the uh, the wage round, which seems to be coming in rather higher, uh, it's generally quite difficult for the japanese seemingly to get any traction in terms of cpi inflation, but we'll see. I mean it's uh, it's early days yet, but a weaker yet is clearly one of the things that will will help them.

Speaker 2: 11:22

Um, is this the correct call? Is it a direct manipulation? Is Japan a stalking, also the yellow stalkers? I don't know, but it seems to agree with the facts and my view has been that one of the most important decisions over the last five to 10 years has been the Shanghai Accord. That was something that people can read about, but it came out of the Shanghai G20 meeting in 2016. And it was an agreement among those countries to try and get the US dollar down, but it basically morphed into an exchange rate basket, if you like, where all the Asia Pacific currencies pretty much flatlining against the Chinese yuan and it was putting the Chinese yuan in a strong position to be a regional standard of value, and I think that's what the US clearly does not want, and any attempts to de-seat, if you like, or unseat the yuan have got to be welcomed, and I think this is a direct attempt to do that got to be welcomed and I think this is a direct attempt to do that.

Speaker 1: 12:31

Do you get a sense of how strong the coordination is among central banks when it comes to these liquidity surges? Meaning is Powell calling up different central bank heads and saying, listen, on this date there's going to be a bunch of liquidity. Do you want to join us or not? I mean, what is the coordination dynamic when it comes to all these central banks that are basically trying to manage their currency through flows?

Speaker 2: 12:48

Well, I think the answer is that clearly in crises that does happen.

Speaker 2: 12:51

We know that there is direct coordination Outside of crises. There is a lot of dialogue that goes on between senior central bankers across the major economies, that's for sure. Is there a coordinated move at the moment? I don't believe there is. On the other hand, that every central bank or every policy maker in a major economy will be looking at their currency against the US dollar and getting concerned If the Federal Reserve eases policy and I'm not saying that from an interest rate only perspective.

Speaker 2: 13:25

I'm thinking of that in terms of what they're doing in terms of liquidity provision as well but if they ease policy in a way that causes the dollar to weaken, I think that what you will see is many other countries joining in with that, simply because economies need stimulus, and I think that many governments will actually, or many authorities will, take the opportunity to follow the Fed's lead. We know that emerging markets, in many cases, are itching to do that because they've actually been leading in cases. We know the ECB has been lagging, but they're basically desperate to ease some of the rhetoric that's coming out. Now.

Speaker 1: 14:01

The Bank of Japan is also easing, despite, as I say, uh moving to a zero, uh to a zero interest rate regime from negative, uh, they're still expanding, uh, the central bank balance sheet so I I put out a uh, a post on x a little bit earlier today saying you know the the fed got the market to think six interest rate cuts were coming and then, in the span of four or five months, now we're starting to think that they might actually raise rates. And I reference that not even as a criticism against the Fed, just against this point that nobody knows what tomorrow brings. And it's extraordinarily volatile Policy reactions are seemingly happening now faster and faster. What did change, I mean, is the re-acceleration concern around inflation. First of all, is it justified? But then too, if it is justified, is it because the six-rate cut narrative that was out there basically was a form of rate cutting without the Fed having to do a single thing?

Speaker 2: 15:36

Well, I think I mean put it this way. I think that what I would argue here is that if you look at rate expectations, so if you look at Fed funds, futures, or you strip out from the yield curve what the market's expecting in terms of the rate profile, as you rightly say, michael I mean a few months ago they were talking of six rate cuts. Now it's been slimmed down to maybe two, maybe one, maybe none at all, who knows. But these expectations flip around. But through that period the market's generally gone up. So the market hasn't really been looking, I would argue, too closely at rate expectations. It's been driven fundamentally by liquidity. It's been driven fundamentally by liquidity and liquidity has been pushed into the system and, as I argue, it's come directly through the Fed balance sheet.

Speaker 2: 16:25

Despite the rhetoric that the Federal Reserve say they're undertaking QT, that does not mean that they're not putting liquidity into the system. Now how do we square that? The reason being is that the balance sheet of the Federal Reserve has been shrinking because they've been letting treasurers roll off, as the headline has rightly been saying. They have been doing QT according to their rhetoric or their argument, but the fact is that liquidity, which is not the same thing has still been going in. Now. How does that work?

Speaker 2: 17:05

Simply because to work out liquidity you've got to look at Fed credit.

Speaker 2: 17:07

And anybody who's interested, just wait until 4.30 tonight and you will see a release called the H4.1, which the Federal Reserve puts out every week, and you can get from that Fed credit, which is how much the asset side of the Fed balance sheet increases.

Speaker 2: 17:21

And what you've got to net out from that is a set number of items, but fundamentally it's the size of the TGA, which is the Treasury General Account, which is the amount of money that the US government holds at the Fed. In other words, it's money that's not circulating the system, but it's just there idle in a bank account. And a similar account which is called the reverse repo facility, which is another account where, principally, money market funds and banks put money on the Fed balance sheet, but it's not circulating in the system. Once you net those two figures out from Fed credit, you effectively get a number which measures the amount of liquidity in US money markets, which is equivalent to US bank reserves. Us bank reserves have increased significantly over the last 12 months, pari-pursue with what Wall Street's done, and that's the key driver, or a key driver. Certainly, for the moment it's a key driver.

Speaker 1: 18:17

So for the past month and a half I've been posting in an ominous way because you know I have a flair for the dramatic on X. Gold is sending a warning and I had a conversation with an advisor earlier today who knows that I've been saying that and he said you know, the issue with that saying gold is sending a warning is you don't know what the warning is. Is the warning that the Fed's going to cut rates or is the warning the Fed's going to actually erase rates? Is the warning around war or is it just FOMO momentum? And it's not a warning at all. You see a lot of studies, as I have, around what tends to cause gold to have momentum, and usually it's around negative real rates, which clearly is not the case here. What do you make of the move in gold and is it just one of those things where it's another asset class that's absorbing liquidity, or is there something else maybe happening at the periphery that's causing some reallocation to a non-correlated asset, because there's worry about correlations?

Speaker 2: 19:12

Okay, well, I did a detailed analysis in my Substack Capital Wars a week or so ago where we actually looked at the sensitivity of different assets to liquidity, and basically gold.

Speaker 2: 19:25

Let me start with gold. Gold is a very sensitive asset and if liquidity increases, let's say by 10%, what the data show is that the gold price tends to move up on average by around about 15%. So you've got to kind of sensitivity factor one and a half times in terms of the growth of liquidity versus the movement in gold. That's normally the case. Now, as you correctly say, there's also a cycle effect there that comes in from real interest rates. I tend to think of liquidity as being the dominant trend that's driving gold over the medium term, but we've got to acknowledge there is a cycle there and that cycle is there because of the cost of carry, of holding a gold position. So if real interest rates go up in the US. So look at the tips yield, which is normally a great benchmark. Look at the tips yield. The tips yield, when it moves up, tends to signal a major drop in gold, and when the tips yield drops, you tend to find the gold market rallying. Now, that is the norm and that's been a pretty good relation over many, many years, but it's broken down, particularly over the last two years, and gold is diverging from a rising real interest rate level. So something else is going on Now. Is that something else? Geopolitical concerns? Well, it may be, but I don't think the geopolitical concerns really influence gold over the long term. There may be a blip for a week or whatever, but it's not a long-term phenomenon.

Speaker 2: 20:51

What drives gold over the medium term is monetary inflation. Monetary inflation is expanding liquidity. That's what it is essentially, and what you've got is a significant increase in monetary liquidity going into the system and gold is picking up a bid because of that. Gold broke out pretty much coincident when Governor Wallace said we are going to at the Federal Reserve thinking about, in other words, they're going to start to buy at the shorter end of the treasury market. Now, if they're doing that and that is a signal that the treasury is going to start issuing at the shorter end that it may be you can join those dots.

Speaker 2: 21:29

That is monetization. That is what we've got to be concerned about and that's when the gold market picked up. So gold bugs or gold analysts clearly have got a similar concern and I believe that if you've got which I do believe is happening a situation where monetary inflation is going to rise dramatically or significantly, let's say, over the medium term, because of the very bad fiscal finances that the entire West faces, you're going to have to have more participation from banks and the central banks in treasury purchases. I'm equivocal about whether it's the high street banks that buy the treasuries or it's the Fed, but there's going to be some combination of the two that are buying. That's monetization. Investors need to hedge against that monetary inflation risk.

Speaker 1: 22:51

But has it all been surprising that gold has been, at least in the short term, the real beneficiary of that versus Bitcoin? I mean, if the argument is that it's around monetization and central bank discipline and liquidity, I mean, bitcoin has been struggling around these levels and gold, surprisingly, for the last two years, has actually outperformed Bitcoin.

Speaker 2: 23:11

Over two years, is that right? Yeah, over two years. Okay, well, I defer to your-. Well, logically it's been down less, right, I mean it's more of a drawdown. But I think that if you look at the sensitivity, if you do an analysis and again I go back to the capital or sub-stack piece I wrote what that says is, if you look at the sensitivity of different asset classes crypto, in other words, ethereum or whatever have a much, much higher sensitivity, uh, to liquidity than gold does. However, the data shows that they move early, so they're one of the first beneficiaries and it takes a few months for gold to get some traction out of the liquidity increase. So maybe what we're seeing is consistent in that regard.

Speaker 2: 23:53

One's also got to say that, you know, in that equation there's also also got to say that in that equation there's also Wall Street. Wall Street normally does as well benefit from rising liquidity and clearly it has it's been a key beneficiary over the course of the last 18 months, as we know. But then you also get, slightly later in the cycle, commodity prices coming through and we're starting to see now, I think, a very significant liftoff in the commodity space. Now that is partly because commodities tend to follow gold. In other words, the currency denomination goes up and commodity prices being priced in dollars will rise as well if the gold price is going up. But you've also got a real economy effect coming through there, which is the real economy is starting to get traction. In my view, that's what I think the markets are telling us and that is what I think the latest economic data is telling us.

Speaker 1: 24:44

So I think it's actually, if you play it out to the logical conclusion, that's a pretty scary scenario, and I say that purely because. So you've got commodity momentum coming back on cost push inflationary pressure. Perhaps China has bottomed. I mean, I happen to think that's more likely than not. Now, how long that lasts because of how much debt they have, that's a whole different discussion. But at least animal spirits could cause China to work, which causes commodities to get even more upward momentum. That seems like we're headed for that re-acceleration phase of the 70s of inflation which everyone was afraid of and thought it wouldn't happen, and now it seems almost like it's a fit to complete.

Speaker 2: 25:20

Yeah, I think this is a risk. I mean I'm not going to deny that. I mean the plain fact is that strong economies don't have strong financial markets and what you've got to be most wary of is rapid acceleration, and we seem to be getting that right now. So maybe this is going to cause an air pocket in markets and that coincides with a period where, uh, in april, maybe early may you get a surge of money coming into the tga as people pay their tax bills and that drains money out of markets. And I think the you know janet's got to be certainly uh alert to that, because what you don't want is bank reserves to start cratering and to open up another wound in the regional banking industry ahead of an election, bad Tony.

Speaker 1: 26:00

Yeah, and actually it's interesting to see even the reaction on that inflation report from yesterday, Wednesday. Regional banks took it on the chin like no other, as well as homebuilders, by the way, which I thought was interesting. Maybe if the bet is that we're not done with inflation, then the Fed mortgage rates would have to keep on rising, and if that's the case, because shelter is a big part of that inflation stickiness, that has a little of an implication, but at some point this becomes, I would think, self-correcting. It's like the more inflation keeps on rising against already elevated interest expense, consumers are not going to be able to afford anything. I mean now, people say that, but the reality is, when it happens, nobody knows but there is some breaking point.

Speaker 2: 26:41

Yeah, I think that's right. I mean, I think that you know, you've got to remember that this is a cycle and we've got to think cyclically. And you know, at the end of the day, I'm bearish about bond markets in the medium term, simply because I think, as I said, alluded to, fiscal finances are shot through because we're fighting a war on two fronts here against China, albeit a Cold War, and a war against demographics, and the numbers just don't add up and the numbers are frightening. Just look at the Congressional Budget Office website if you don't believe what I'm saying. And I'm not hitting on the US, because the US is the cleanest shirt in the laundry here. The rest of the West is completely shot through.

Speaker 2: 27:20

So it's all about the fact that monetary inflation has got to come and therefore the bond markets don't look great. But hey, look at the experience we've had over past decades through history and what it shows is the governments don't go quietly and if they want people to buy their debt, what they do is they create a recession. They'll hit hard with the inflation discipline, but I don't think that's a 2024 event. It may be a 2025 event. They may be wanting to get the economy crashing in 2025, so they can sell an awful lot of debt. That would be a clever move debt.

Speaker 1: 27:56

That would be a clever move. By the way, that's a move that's proven throughout history. I've used that line before and I've shown the data on this. You want to save treasuries. You crash stocks. I mean it's just like that. And, by the way, if you look at the top 1% of declines for the S&P 500, using daily data, you go back to 1961 and you look at long duration treasuries, in those massive declines for equities, treasury yields collapse. So you're right, it does create the demand. Now, of course, you want to time it with the auctions.

Speaker 1: 28:22

That's maybe a little bit too acute of an approach, but that does bring with it sort of the question of timeframe for how long the liquidity kind of keeps things elevated. Now, look, I know a lot of people are still in the melt-up camp. It's clearly been right, although I think right just largely for large cap market cap weighted averages. Again, I go back to small caps also 2000,. Not anywhere near 2020 highs. People say that doesn't matter because most people are indexed, no disagreements. But at some point, to use your wording, the refinancing risk for small caps does put them at risk of being ongoing concerns, which means at some point those companies could go bankrupt, and that creates actual, real employment issues. But how long does this liquidity surge really keep going? I think you mentioned 2025, but why then? What is it about that timeframe that makes it likely that that's going to slow down?

Speaker 2: 29:10

Because I think that I would tackle that from two perspectives. One is that the average length of the cycle, uh, in terms of liquidity, has been five to six years, um. And secondly, I mean, in other words, that if you look at that cycle, uh, we figured the bottom came in october, september, october of 2022. Uh, we envisioned that, uh, the peak would be sometime in late 2025 and the path of the cycle is already following that narrative, pretty much in step. So, although it won't be a straight line up, I mean, we're still pretty confident that the liquidity cycle will be going up and peaking around about the latter part of 2025. So that's point number one.

Speaker 2: 29:49

Point number two is that I hear what you say on inflation and about the acceleration in the economy, and I think that one of the things that is maybe surprising maybe a lot of commentators right now is perhaps how firm certain parts and I stress the word certain parts of economies around the world are. I mean, the data that we look at, for example, shows that shipping activity has picked up fairly decisively in the last couple of months. Now, it's difficult to know whether that is a clear, if you like, unbiased pickup or whether closures of various ports and canals because of big Gaza or be it problems elsewhere, are actually causing reallocations of shipping and it's affecting the data. I don't know, but it looks as if there's a clear pickup going on in the shipping markets that is being underscored by what's happening in the commodity markets. The two normally go together, so it looks like we're getting some sort of turn in that way.

Speaker 2: 30:46

But all this is adding up to, or throwing fuel on, the whole idea that, with a liquidity expansion and rising commodity markets, what you've got is the potential for an inflation problem out there, and policymakers will have to tackle that, and my best guess is 25 when they do that, because 24 is the election year. And why do you want to start now? That doesn't make sense. Just wait sometime next year and then start hitting the brake pedal hard. So that would be my explanation as to why that cycle occurs in that way.

Speaker 1: 31:18

How much of a wild card do you think oil could be in this? Because I think if oil really starts to accelerate at a much faster pace and who knows whether it's geopolitical Middle East tensions, war, whatever it would be like we saw a week ago on Thursday, those concerns that caused the world to spike caused the flight to safety and treasury stocks to go down hard. How could that throw things off, if at all? Because I would think if oil really starts to skyrocket here, you might have to do a panic rate hike.

Speaker 2: 31:51

Yeah, I think that's entirely possible.

Speaker 2: 31:53

I mean, if mean, if you look at, I mean the normal course of cycles, as you probably know, is that, uh, when you start to see big spikes in in oil markets, uh, you get, uh, you get stock market crashes. I mean, this is, this is the norm, and never say never, because if you get, I mean, at the end of the day, what you're looking at is a world economy, uh and I'm talking here not of the west, but more generally which is effectively becoming more energy intensive or more oil intensive over time. As they mature, as they develop, and basically, as these economies, particularly China and Asia, pick up, marginal demand for oil, and particularly gas, is going to start to step up significantly. And then I think you do start to see some meaningful jumps in prices, because I don't believe there is the elasticity in supply that there maybe once was. Now, I'm not an oil expert, so this is more a feeling or a hunch rather than analysis, but that would be my concern. And if that got to be, that's going to feed through directly into inflation numbers.

Speaker 1: 32:57

Uh, because you know, we, we know that, uh, you know, the cost of driving is a bigger, big impact in the us yeah, it does seem like natural gas is starting to show some momentum again, right, so it could very well be that, and you probably know this better than I do. Uh, perception around inflation is very, very tied to the gas prices, more so than anything else. Yeah, completely, completely agree with that. One of the questions I got from X, from somebody, was does the yield curve inversion even matter anymore? You said in the beginning of the conversation you alluded to this idea that we're in this world where a lot of the old rules are not mattering, are not making sense. Now, I'm always hesitant in thinking that way because that sounds an awful lot like. This. Time is different and there's always false signals in any indicator set. So maybe it's a false signal, maybe not, but I am curious if you think the yield curve matters when we have all this liquidity manipulation.

Speaker 2: 33:56

Okay, well, the answer is the yield curve matters when we have all this liquidity manipulation. Okay, well, the answer is the yield curve matters, but it doesn't matter at the moment, if that's a good way of answering the question. The reason it matters is the yield curve is a pretty good barometer of liquidity in the system and, going back to my days at Salomon Brothers, one of the things that we used to look at very closely because the whole firm was geared towards looking at flow of funds and liquidity and particularly trading the yield curve is that basically, periods of yield curve steepening were largely about liquidity coming into markets and yield curve flattenings were about liquidity being drained from markets. So the yield curve slope was a pretty good proxy for generally liquidity moves. Now, having said that, is the yield curve a great predictor of the economy? The answer is no. It's not Putting a wonkish hat on.

Speaker 2: 34:44

I wrote a piece many years ago in the Journal of Fixed Income which did an analysis of the efficacy of the yield curve and the conclusion was that actually the yield curve in general generically is a pretty good predictor. But the trouble is you never know which one which maturity spread. Is it the one three year? Is it the one 10 year? Is it the 210 year? Is it the 510? Uh, you only know backwards, uh. In other words, what that's telling you is the curvature, uh, of the term structure is actually one of the most important ingredients in understanding the uh, the impact the yield curve has on the economy. Now, what is the story right now? The story right now is that the yield curve is the true yield curve, is not inverted. The actual yield curve is, and the reason that I make that statement is that the 10-year yield, which is what people are using at their benchmark, has been biased downwards, uh, significantly by the change, or the mix, the change in the mix of issuance by the us treasury. Now, I can substantiate all these things statistically, but you're going to have to hear me, uh, try and describe it. Um, uh, you know, uh, in terms of words, a good benchmark of what is a risk-free asset in the system.

Speaker 2: 35:58

An alternative is to look at the agency mortgage market, and the agency mortgage market is different from the treasury market because it tends to be longer duration and more convex. Again, this is sort of wonkish bond speak, but if you make adjustments, you can basically artificially create out of the mortgage market a synthetic 10-year bond, treasury bond equivalent. It's a safe asset. After all, the Federal Reserve holds agency bonds in its portfolio, so risk is similar between these securities. So if you make those adjustments and get a 10-year yield, what you find is that, generally speaking, the adjusted 10-year yield which you can get, it's approximately 150 basis points different normally from the 10-year yield. But if you make that adjustment, what you find is that where the 10-year yield should be right now is over 5%. So in other words, looking at what the agency mortgage market is telling you, is that inferred from that the risk-free 10-year yield is over 5%.

Speaker 2: 37:06

And where are we now? We're what did I just say? 4.6 or thereabouts. It's inching up all the time. It's moving back that way. It been hugely depressed below the where the mortgage benchmark is because of the big switch to bill issuance by janet over the last few quarters, which has basically starved the market of coupons, and that has meant that treasury bonds have been bid up artificially. Their yields have been depressed and that is what's caused a lot of the inversion in the curve. Now if you recalibrate the yield curve and use the synthetic mortgage, the synthetic 10-year, from the mortgage market, you find, number one, that the yield curve never inverted and number two, that it's been steepening for the last 12 months. Now, if you then put that back in the normal yield curve frame and say I'm looking at now an adjusted yield curve with a mortgage market input, what that conclusion is that the US economy should be beginning to turn around about now and should be accelerating, and it should never have gone into recession, which it didn't.

Speaker 1: 38:15

If you don't publish that you shouldn't an adjusted yield curve, because I think that would be fascinating for people to just track, because they always I always go back to this line amateurs look to the right at the equal sign. Pros look to the left, right, right, and you're looking to the left as far as that. So I don't know if you do that for the Substack but-.

Speaker 2: 38:31

I can put it on Substack. We actually do it for our institutional class, but I'll do it for the Substack.

Speaker 1: 38:35

Everybody. Also, make sure you sign up to Michael Al's Substack. I have it on the bottom there capitalwarssubstackcom. Okay, so a lot of interesting topics we've hit here. You know I've put a lot of focus on credit spreads and I've been incredibly wrong on a credit event thesis, although I still think it's out there, but it's always about path, not prediction. Spreads keep on getting narrower and narrower. I'm actually blown away by it, especially relative to default in the real economy, default rates rising relative to spreads being as tight as they are, small caps could be being worried about default risk. At what point do credit spreads start to rise? Is the simplest answer the right one, meaning it's when liquidity stops? Robert Leonard.

Speaker 2: 39:18

I think that's a key factor. I mean, I think there's a whole lot of things which have come into effect. The credit markets, I mean, one has been this point that I just made about the yield curve, in the sense that if you looked at the conventional yield curve as published and you saw the inversion, you'd have been expecting a recession and you'd have been very wary about the credit markets including many people were. If you started off from the frame of saying, well, actually, the true yield curve is not inverting and it's now steepening, you'd have had a much more benign view of credit. And I think that's point number one. I think point number two is you've got to take into account the maturity wall which is out there.

Speaker 2: 39:55

A lot of companies did refinancing at low rates when rates were low, and so that's, I think, another factor.

Speaker 2: 40:03

And I think the third factor is that if you look at data on I mean we look at this very closely data on the cash flow generation of the US corporate sector, it looks to be remarkably good, and that is actually one of the reasons that we've been upbeat on the dollar, because that cash flow generation is actually one of the factors that tends to drive the dollar over the long term and again that seems to be happening.

Speaker 2: 40:25

So that would be my explanation for the credit markets. Now that doesn't mean to say that you're not going to get problems, and I think you will get problems. And the issue out there is that the small and mid-cap area of the US, or the smaller company area, is much, much more sensitive to rates being high for a sustained period. And the longer the rates stay high, the concern I would have is the US economy suffers in that tail, in that small to mid-cap tail, and that is what's important for the American economy the long-term productivity growth and therefore the longer the rates stay up there, the more the productivity trend will be dented, and that's got to be a concern for policy makers.

Speaker 1: 41:09

And that would cause unemployment to rise. That's why I never quite understood the argument that small caps don't matter. They matter a lot, right. It's just a matter to investment portfolios because they're a small portion of the market cap weighted average. Yeah, in terms of the real economy, it's it's a lesson Right. It's a lesson Exactly, exactly right. Speaking about jobs, from what I've seen, it seems like all the jobs data is primarily government and or part-time work, not exactly, I would argue, a very healthy employment situation. But since we're talking about looking to the left of the equal sign, any thoughts on the sort of narratives that say that this jobs data is not anywhere near as robust as they make it out to be, that it's cooked or it can be revised lower, or is there no merit to any of?

Speaker 2: 42:32

that Well? No, I mean, I've always been deeply skeptical of employment data. Anyway, I've never really put a great deal of weight on it, so I'm probably the wrong person to ask. In truth, I mean, I always think the employment data is a trailing indicator anyway, and I never really understood why Wall Street gets so caught up about the monthly employment number. I find it bizarre. I mean, there's much better indicators of the strength of the economy out there, but everyone's fixated on this All right.

Speaker 1: 43:00

So, speaking about the dollar and strengthening the dollar, there's going to be a point where there's some real stress because it will create a funding crisis. In October of 2022, when the dollar was pushing higher and higher, every single magazine cover had dollar wrecking ball. All right, everyone was talking about the dollar wrecking ball. Back then I actually thought it was a top. I even posted that. I said, yeah, the dollar finished, and then that preceded the October low in equities. I don't see too many people talking about the dollar wrecking ball now. At least I don't see the media talking about it as much, but presumably the risks are the same, if not more heightened, compared to what they were in 2022. At what point is the dollar strength a real issue where it could cause some kind of tail event overseas?

Speaker 2: 43:43

Well, I think we're getting to the stage now where the dollar is becoming an issue, and I would suspect that there is a lot of petitioning of Janet by foreign governments to say that we don't want the US dollar to be a lot stronger than where it is now. But I think, to go back to my point about the yen and what's maybe happening in China, I think that the other question to ask is why haven't there been complaints from the US Treasury about the yen wrecking ball? Because there was, if I remember, not that many years ago, maybe two or three years ago. The US Treasury was very concerned about the fall in the Vietnamese dong, which was a minor currency when it comes to US trade, but they've not said a word about the collapse in the yen, where Japan is a major trading partner of the US. So there's no smoke without fire here, and I rather wonder why the Treasury has been very quiet about unfair competition and pushing the yen down now. I think this is part of a of a dealer conspiracy. I've always felt that you know, if there is any manipulation or every policy moves, it comes via currencies, whether it's great target bands or whatever, or whatever governments do, and I think there is agreement there on where currencies sit.

Speaker 2: 45:03

I think that the yuan is the target right now and I would, as I say, I go back to my point and I may be completely wrong here with the wrong end of the stick, but my view is that the reason that you've got this increasing dialogue between Janet and the Chinese is that there is some quid pro quo coming Now, at times historically where the TGA has rocketed higher and liquidity has come out of the system and the treasurer's hands have been tied.

Speaker 2: 45:31

Looking back, my interpretation is they've often moved to talking the dollar lower to try and increase liquidity in the system during those periods, those interregnums, and maybe something is cooking again. So watch this space. I mean, I don't know if I'm going to be right or wrong here, but certainly one of the things I'm looking at is the dot on the dollar, and I would suspect there may be some deal on that. What is that deal? I don't know. Is it a trade deal? Is it a surreptitious deal for the Chinese to buy more treasuries? I don't know, but talking the dollar lower may be the quid pro quo in some agreement. Maybe that would make sense here.

Speaker 1: 46:12

All right. So you're immersed in this liquidity data. You put a lot of great research. I am curious how do you even put that data together? What are your sources of determining the state of global liquidity and how often does that really change? Like how real time is that?

Speaker 2: 46:27

Okay, well, let me answer those questions. What is liquidity, first of all? I mean liquidity is basically a measure of. We think of it in terms of funding liquidity. You can have an alternative definition of market liquidity, which is a measure of market depth, in other words, what are the volumes that you can trade in without moving prices too much? That's a market liquidity measure. That's not what I'm talking about. We're talking about funding liquidity. Are there funds available, credit available, to basically make transactions?

Speaker 2: 47:00

We're looking fundamentally at financial markets and to gauge that, what we look at is essentially the asset side of the financial sector balance sheet worldwide. We're looking at shorter dated instruments on the asset side of balance sheets, so it's things like shorter term securities, repos, bank lending, et cetera. We gather that data worldwide because liquidity is fungible Certainly it's fungible until it isn't and that data is a big computational exercise. I first began doing that at Salomon Brothers. It was then done by telephone and by fax and it was done across then major economies worldwide, phoning up the central banks and the treasury ministries. Whatever that data was gathered and put together in terms of a database looking at how global liquidity moved, is the Bank Negara of Malaysia, who were extremely private about their foreign exchange transactions, got in touch with the seniors at Salon Brothers and said look, we think we've got a mole in Bank Negara who's releasing data on our balance sheet and foreign exchange reserves because you're publishing it. We want to find out who that is.

Speaker 2: 48:19

What they hadn't realized is that actually that data is fully transparent. It's in the public domain. You just have to know where to get it. We want to find out who that is. What they hadn't realized is that actually that data is fully transparent. It's in the public domain. You just have to know where to get it. We happen to be getting it, so the data is out there in the public domain. There's nothing we're getting that is secretive in that sense. We compile it. We now cover 90 economies worldwide. It's a big data dump. It's now done electronically rather than through faxes and telephones. We have it automatically done. We do that increasingly weekly and we're actually moving to a system hopefully in the next couple of months, which has been a big exercise over the last few years of actually doing a daily nowcast equivalent for liquidity, which will actually give a global liquidity index on a daily basis. So that's something that we hopefully can progress to.

Speaker 1: 49:10

Of those 90 countries that you're tracking liquidity from, are there certain countries that have been surprising in terms of how much they've been doing, that maybe are not getting coverage. That it kind of makes you raise your eyebrow a little bit.

Speaker 2: 49:25

I think you can say that a number of regards. I think that if you look at cross-border flows that dimensionally, I should say that we look at three particular conduits of liquidity. We look at what the central banks are doing, their provision. We look at what the private sector is doing in terms of what it's doing. That may include things like conventional banks, shadow banks, corporate cash flows, et cetera, that are going into the system. All that element and the third bit is cross-border flows.

Speaker 2: 49:48

Now, I think the way you're seeing surprises, right now at least, is in the cross-border flow category, where you've seen a lot of money moving into countries like India. Money has clearly moved out of China significantly. India is a recipient of that. A lot of money has moved into Mexico, for example, in terms of cross-border flows. So these things are indicative of changing trade and geopolitics, I guess. In terms of what is the most important, if you had to push me in a room and say, look, you're only allowed two pieces of information, what are they? The two most important central banks worldwide are the Federal Reserve, unquestionably, and the People's Bank of China. The Federal Reserve matters a lot more for financial market movements. The People's Bank of China matters more for the world industrial economy. So you've got to monitor both. They're critical.

Speaker 1: 50:44

What would cause you to change your thesis that they're not going to tackle higher inflation? All this liquidity jamming inflation higher until next year? I mean, is there some kind of tale of it or something that would just throw everything off to you?

Speaker 2: 50:59

Well, I guess, if you had I mean this, uh, this will, I think, come down into the realm of us politics and if you had a sufficiently large spike in inflation where the administration felt they had to do something uh, because inflation was becoming a major bogey for uh, for voters then I think you could. You could see something. But you know, I something. But I think the reality, as far as I can see, is that on paper, looking at the strength of the US economy and looking at the inflation data, the Federal Reserve should not be cutting interest rates this year. They should be keeping rates higher for longer. But J-PAL is telling us that they're going to cut, and maybe that's only a token cut. But this seems like it's the realm of politics, not economics right now. So I suspect that's the way it's going to go.

Speaker 1: 51:50

Yeah, I'm actually blown away by how brazen Biden has been in saying, well, we're going to get a rate cut or maybe now it's going to be in June. I mean, I don't recall. I mean maybe it's always happens I always go back to. I remember an interview that Greenspan did a decade plus ago when he came out with his book Age of Turbulence, and he made it a point to the person that was interviewing him that he never once in his tenure as chair of the Fed had a politician asking him to raise rates. It was always to lower rates. There was always a buy-in. Are we at a juncture in history now where really the central bank is not independent? I mean, when Biden says he's expecting a cut, it's not because he's expecting it, it's because he's ordering it.

Speaker 2: 52:37

Well, I guess, at the end of the day, central banks are agencies of government, aren't they? At the end of the day, central banks are agencies of government, aren't they? So are they truly independent? Maybe the Federal Reserve is one of the more independent institutions globally vis-a-vis the government, but still you've got to accept the fact. I mean, the reality is that Janet used to serve as Fed chair. I mean she's Treasury Secretary, so I mean there's got to be some connectivity there anyway. But I think generally, I mean I think Treasury Secretary, so I mean there's got to be some connectivity there anyway. But I think generally, I mean I think there's a lot less independence than is made out in truth.

Speaker 2: 53:11

And if push comes to shove, at the end of the day, what really matters for both central banks and finance ministries worldwide is the integrity of the government debt markets, of the government debt markets, and I've long said that at the end of the day okay, we can pontificate about how inflation is the main target or employment is the main target of policy makers what really matters is the integrity of the sovereign debt markets. They need to get their debt sold and that, if push comes to shove, is what they really focus on. Just look at the British case, the British guilt crisis in September of 2022. All the inflation targeting and the decision to go to QT were immediately thrown out of the window where they had to maintain yields or try and keep yields down. This was a wake-up call, I think, for governments everywhere. Get if the proverbial you know shit hits the fan, then, with alacrity, policymakers move and try and try and suppress yield spikes and make sure the banks keep functioning.

Speaker 2: 54:11

That's what it's all about, and I look very closely at the Federal Reserve and have done for years. What you could see is that the Federal Reserve through the 1990s, under Greenspan, used to make indirect but actually more meaningful interventions in markets and that's when it really started to grow. But I think in the last decade, 15 years, the Fed has sort of basically had both arms around the markets. I mean it's dominant. I mean, I think the reality was, if you go back to the period just before the global financial crisis, the Federal Reserve lost control of the dollar credit system and what they've been doing for much of the last 15 years is trying to get that control back, and I think they have got it back, and what I would say is that that's what really matters. If they lose control of the financial system again, they'll come back with speed and trying to control things. It's the bond markets and the sovereign bond markets which are really the critical factor.

Speaker 1: 55:18

Michael, as we wrap up, for those who want to track more of your thoughts, more of your work, where would you point them to? Because nobody's faster than you when it comes to identifying liquidity.

Speaker 2: 55:27

Well, that's very kind. Substack is a great way in. That's the capital war substack. We do occasional tweets on Twitter or Exit with handle at cross-border cap and if you want an institutional service, we provide that with full data access. A lot of quant funds use our data, for example, in terms of running portfolios, but that is available on crossbordercapitalcom.

Speaker 1: 55:54

Everybody. Please make sure you follow Mr Al and follow me on X. Subscribe on YouTube. Like I said, this has been an experiment. Hopefully everybody enjoyed it. I'm going to try and do these once a week. I always appreciate Michael's thoughtfulness, work and overall he's a good guy and I like his first name. So thank everybody for joining and we'll see you next time. Appreciate it. Thanks, Mike. Thanks so much.