Speaker 1The AI build out is draining liquidity and Michael Howell says the global liquidity cycle has turned. He's calling for a sharp slowdown in 2027 for Bitcoin to retest 70,000 for bonds to beat stocks and a bottom in liquidity by late 2027. Monetary Matters viewers get 20% off an annual subscription to Michael Howell's Capital Wars sub stack link in the description. First, a word from today's sponsor. This episode is brought to you by Sarmaya Partners, who manages the Return to Tangibles ETF, LENS, ticker L-E-N-S, the Sarmaya thematics ETF, built for a return to tangibles. Learn more at SarmayaETF.com and see the show notes for disclosures. Let's get into it. I'm joined once again by the liquidity godfather, Michael Howell of the Capital Wars sub stack. Michael, great to see you. Always a pleasure to be here. How are you thinking about markets right now? Just had the Fed meeting, some balance sheet announcements, but how are you measuring liquidity across the indices that you look at? Central bank liquidity, cross-border, private sector, the rest, and then its implications for asset markets. Just give us a broad view to start out
Speaker 2with. Well, I think the broad picture is that the liquidity cycle is going down. I mean, that's for sure. It peaked in late 2025, and that was after an upward run of pretty much three years. So it's inflected downwards. The important thing to say is that this is really measuring the growth of liquidity into financial markets. So it's not looking at the level. The level is still relatively high. But what we're seeing is a very clear, slowdown. And I would contend that those features are becoming more apparent in markets. And the backdrop is that we're moving through the investment phases we've just come through and maybe ended the phase that we tend to describe as speculative. And that's really been going on for almost a year now. And that phase is really saying that it's kind of late cycle. You can still make money in markets, but the volatility is high. So the quality of those returns is pretty poor. And really underneath, you've got a lot of mixed performance. So I think we've seen that really across many of the indexes. I mean, the Russell 2000 looks like it's in a bear market. You're seeing a lot of defensive stocks really outperforming now. So things like healthcare, energy has clearly been on a roll through most of this year. Again, all sort of late cycle features. And we're moving into, let's say, the fourth phase, which is basically saying this is a turbulence phase where things get worse, where liquidity gets crimped more. And it becomes more of a struggle for people to make money. And you really want more defensiveness. Particularly a longer duration government bonds, which kind of flies in the face of many press headlines over the recent month. But nonetheless, that's what the data tell us. I think you've got to put that in the context of yesterday's Fed meeting as well. I mean, what is the Fed really trying to do in all this?
Speaker 1So in terms of liquidity, the vast sums that AI is consuming of capital to invest in data centers and chips, that sounds positive. And it is for the data center build out. But the point, I guess, for our purposes here, is that that is, a consumer of liquidity. It is not a producer of liquidity.
Speaker 2Yeah, I mean, that's a plain fact. And I think if you look at previous booms with what you might call transformative technologies, while they're clearly fantastic over the long term, and they're really world changing, the fact is they typically end in recessions or financial crises. And we've seen that so often in the past. And I think the question is to dig down as to why that is the case. And I think the first thing to say is that, you know, as far as I can see, every capital intensive industry is basically cyclical at the end of the day. And that's what we've got to remember. But the trouble is that most investors, and most proponents of AI or SI or whatever you want to call it, basically see this as a long term trend, not as a cycle. The fact is that capital intensive industries, period, are cyclical. That's the reality we've got to face. Go back to fiber optic cable, about 20 years ago. I mean, that was seen as a huge boom, but it turned out to be remarkably cyclical with some of the major leading companies in chapter 11 within five years. So I think you've got to remember that. And that's what we've got to keep in mind. And then the other thing is you highlight these things have got to be financed. And the sort of numbers that are being crunched for the debt is basically eye-watering. We're talking maybe not quite at a trillion dollars, but we're getting pretty close to a trillion dollars both this year and next year in terms of the financing demands. Now, if you go back probably not 12 months or maybe even 18 months, the story was very much 80-20 in terms of saying 80% of the funding for the AI build out will become out of cash flow. Now, it seems to be very much the other way. It's flipped. And 20% is cash flow, and maybe 80% is actually coming out of the markets. And we've spoken about the debt load. I mean, the debt load is clearly big, but then there's an equity parallel, which is coming in pretty close behind. So, you know, there's a lot of financing demands ready to come out. And it's that question, which I think we've got to tackle. Is there the capacity in the markets ready to deal with that? And you've got not just this new financing demand coming through on US capital, but you've also got the echo effect of the thing called the debt maturity wall, which is really the echo from the COVID years when a lot of debt was turned out, when policymakers recklessly pushed interest rates down to near zero levels and in cases below zero, encouraging borrowers to take on not only more debt, but to turn out existing debt. A lot of that debt is coming back into the system to be refinanced at higher rates, one would add, in the next few years. So the debt pile is really growing. If you look, if you ever evidence this chart, this chart is basically showing the debt maturity wall. Bear in mind, this is not new debt. This is existing debt that is being refinanced. And the whole, you know, essence or the problem that we face in financial markets is that financial markets are no longer purely new capital raising mechanisms that predominantly mechanisms for rolling over existing debt. They're refinancing systems. And what the chart basically shows is the annual increments worldwide for the advanced economies. of how much this refinancing wall grows or shrinks year by year. And you can see what I've highlighted there is that the GFC and the COVID crisis were basically big years for debt rollovers. And those were clearly causing a lot of tensions. And policymakers responded in both cases. And they added liquidity to the system when you got these refinancing problems. But if you look at the red bars that I put in there for the 26 through 24 years, and again, I stress once more, this is not new debt. This is existing debt that's coming back into the system to be refinanced. And the reason it looks, you know, worrisome is that first of all, you've got to recognize that that really offsets the negative years in 21, 22, and the low years in 23, 24, when you had debt being termed out with low interest rates. So that's coming back into the system now. And the other thing is, it's coming back at much higher interest rates. So what you've got is the debt burden is growing all the time. And that's what you see in this chart. So it's not just the new debt, which I put in the annotation, but you've also got to think about 2 trillion per annum of new federal debt, and you've got potentially a trillion per annum of hyperscaler debt. So these are big, big numbers.
Speaker 1And so a positive on this indicates a large amount of borrowing and refinancing. And I guess a negative means a reduction in the debt stock. So more debt is being paid, back than is being borrowed. Would that be correct?
Speaker 2Yeah. In other words, the debt roll is negative. So in other words, what's happened is that debt has been termed out. So basically, it's been replaced. And therefore, for the next few years, you get a very low number in terms of the debt roll.
Speaker 1And I guess one single stock or two stock analysis for this is like S&Ps and Moody's, which is actually credit rating businesses. I see this chart or a version of this on their investor decks, because they're basically advertising to investors, hey, all this debt has to be refinanced. And so they're basically advertising to investors, hey, all this debt so we're going to be paid to rate it. So I guess that is a bull case for a very small segment of the market. But what are the broad implications of this fact that all this debt has to be refinanced over the next five to six years?
Speaker 2Well, I mean, the question is, is there the liquidity to do it? And the point being is that what we come back to at the end of the day is that if you look at the liquidity cycle, which is basically the flow of money through financial markets. Now, the point about that, as I've already suggested, is that that cycle is turning down. It is turning down from late 2025. This is essentially a debt refinancing cycle. And that's what's really driving the tempo of the fluctuations. So the cycle tends to be between five and six years in terms of length, which is the average maturity of global debt. So that sort of fits into this whole refinancing frame. And if you've got declining liquidity, what you tend to find is increasing tensions in refinancing markets. This particular slide is, it is the essence of the problem. And the problem is that the financial system that has evolved principally since the GFC, although it was evolving before, but the GFC accelerated developments, is that what you've got at the heart of the global monetary system or global financial system is this debt liquidity nexus. And the point being is that debt needs liquidity to roll itself over, in other words, for refinancing because of this term issue. And liquidity needs debt, for the simple reason that liquidity is collateral based now. And as you see in the top left, according to the World Bank, 77% of all global lending is now collateral backed. And all of that collateral backing is existing debt. A lot of it government debt, a lot of it US treasuries, but that clearly is important. So you can see that this particular nexus can spin out of control if you get an inability to turn debt into liquidity or an inability to refinance debt with new liquidity. in the repo collateral markets on the left, which you can see spot by looking at the move index or SOFA spreads, or you get problems in refinancing, the refinancing leg, where you start to see credit spreads blowing out and term premium beginning to drop, term premium being the risk premium on government debt, essentially. And I would argue that you're beginning to see those cracks emerging. Now, if you look at the longer term picture, what you find is that this is the ratio of debt to liquidity for the major advanced economies. And this is basically saying, when you have a harmony, or an equilibrium at about two times debt to liquidity, anything significantly above that causes refinancing problems, which I've annotated there in terms of the various financial crises that you've seen before, I would venture that all financial crises that we've witnessed over that period have been predominantly refinancing crises, an inability to roll debt with liquidity in some form. And then when you go to the other side of that, of that boundary, in other words, below the dotted line, what you find there is that you've got too much liquidity relative to debt. In other words, there's surplus cash, and the vent for that tends to be asset market bubbles. What we've just come through is this huge asset market bubble, because there's been ample liquidity in the system for various reasons. Now, what I've done here is to basically try and put that debt liquidity ratio into a cyclical context. And this is maybe slightly heroic, but it's trying to say, well, okay, if you fit a sine wave to that data, is there any sense in that? And it seems that you get something like a 16-year cycle in this debt liquidity ratio. I mean, that may be, as I say, a big step, but nonetheless, it seems to fit the data quite well. And you've got these very prominent bubbles and these very prominent crises that I've identified. And maybe what we're swinging from is the everything bubble towards the everything bust. So what one's going to look at very closely is the capacity of the financial system to facilitate debt rollover in particular. I mean, the burden that we're carrying on our shoulders of all this debt clearly has a cost at some stage. And that cost is not necessarily just higher interest rates. The cost is actually financial. Financial functioning or economic functioning. And that's the danger that we're basically running into. And it may be to sort of to have a segue ultimately into what the Fed is doing is maybe what the Fed is suggesting in really between the lines.
Speaker 1So Michael, this change from debt to liquidity ratio, it was an extremely, extremely small ratio in 2020, meaning that liquidity was very abundant relative to the debt. Since then, there's been more debt relative to the liquidity as assets have been issued and refinanced. And the Federal Reserve has shrunk its balance sheet and other things we can get into. But it still is below the dotted line, which I guess would be average. So my question to you is, what are the consequences when liquidity and the debt to liquidity ratio, it goes from ample liquidity to just slightly less ample liquidity? Because when people hear from everything bubble to everything bust, they might think that we're, you know, on the other side of the chart, this 240,000, a refinancing tension. But I don't think this chart shows that we're quite there yet. You're just projecting that in, you know, four to five years, if we're on this thing, then it will go on the other line of the chart. Just can you speak to just kind of the slow moving tensions and where we are right now?
Speaker 2Yeah, absolutely. I mean, you've got to ally that with this observation about liquidity, but the liquidity cycle is going down. And the important thing I think to stress here is that liquidity is cyclical, and debt is exponential. So you can see why there are always refinancing tensions in the system. One of the reasons that liquidity or perhaps the main reason that liquidity is going down is not because central banks are tightening, particularly. And I think all the evidence tells us that central banks don't want to tighten. I mean, they're very, very reluctant. They're being sort of pulled, kicking and screaming by the markets to try and tighten. Austerity is not the sort of watchword here. What they want to play is spinning as best they can. As I remember, my former boss, Henry Kaufman from Salomon Brothers said a few years ago, that in fact, three or four years ago, when the Federal Reserve came up with the word transitory for inflation, but I think it's a very good summary of the last five years, he said, this is clearly a Federal Reserve that doesn't want to tighten. And I think the evidence is that you've got so much debt out there, that it's very, very dangerous for policymakers to even think about tightening aggressively again.
Speaker 1Michael, is it just my eyes playing tricks on me? Or do I actually see a small little upsurge, just a tiny little blip of that black line indicating that the GLI, the global liquidity index, maybe has bottomed this year and that it has gone up?
Speaker 2Well, I think that's an interesting observation. And I think if you drill into the data and you find out what is causing that blip, the answer is predominantly what the Federal Reserve was doing last month. And the Federal Reserve has basically added more liquidity to the system. And my read of what the Fed is doing is that they're managing liquidity very closely. And they don't want to engineer a major slump in liquidity markets. And that's why I think one's got to look beyond Fed funds and Fed presser, and all this sort of the ridiculous pantomime that goes around it, and actually try and understand more deeply what the Federal Reserve, and I would also add the Treasury as well, are actually doing to try and manage liquidity conditions in the system. And I think that's what their main focus really is. They want to maintain the integrity of the funding markets. And that's key.
Speaker 1What has the Fed and the Treasury as well, what have they done this year? Tell us, and then also tell us your projection for what could be coming in the future, especially based on the October Fed meeting, which did contain a note about the balance sheet. We'll get into that.
Speaker 2Yeah. So if you look at this chart, this is one of the charts that I noted at the beginning is and this is looking at imbalances in the repo markets. And what we're looking at here is the SOFA, which is the overnight repo rate, minus interest and overnight reserve balances for banks. Take the latter mnemonic as equivalent to Fed funds or more or less. And so what this is showing is what the market is pricing relative to what the Federal Reserve wants or aims in terms of Fed funds rates. Now, I put on that chart a sort of corridor, a gray corridor, which you can argue is sort of a normal zone for this spread. And it's always slightly negative. And that's because SOFA rates are collateralized rates. What you can see on the chart around the end of 2025 is a significant jump or blowout in the spread, which takes us above what I've indicated there is the danger zone. Now, that's suggesting that you get a breakdown in funding conditions. That coincided with a lot of trade fails in terms of inabilities to deliver securities in bond markets. So there were clearly tensions that were going on. And the Federal Reserve reacted very quickly to that. The target level for bank reserves is around $3 trillion. So the Federal Reserve is basically targeting something like $3 trillion for bank reserves. And the orange line is therefore monitoring or telling us how much there is a surplus or a shortfall against that level. And what you can see is around September, October of last year, there became a very big shortfall. And that was a time when the Federal Reserve was talking boldly about shrinking its balance sheet. And seasonal movements in terms of the Treasury general account and various other things basically meant that they could allow bank reserves to drop money market liquidity to shrink by this magnitude. And it was down about $400 billion relative to benchmark levels. Now, what that then caused was big spikes in repo rates. And as you can see, what I've done is to plot the repo spread again, inverted on that right scale. And then what you see is the development of a new policy, which was QE by another name, which was called RMP. So the Fed's acronym department was working late into the night. And that was basically referring to reserve management purchases. And the RMP, program basically restored Fed liquidity to those levels or bank reserves to those levels that you see. And you can more or less identify through this year, the very small fluctuations. Now, if you go back over the last four years, the average deviation around away from bank reserves target, the target level, the minimum level of bank reserves that I identify is around $300 billion average. So there's some big fluctuations. In the last nine months, those average fluctuations have fallen significantly to under $90 billion. So it looks like this is on a weekly basis. So what you can see there is, I think, a deliberate attempt to try and target bank's reserves. Now, what this is really telling us is this is money market liquidity. So they're saying what they want is stable money markets. And they're making sure that there is an ample of reserve regime. And I think what we're moving to is a managed framework. And the other side of that is looking at this chart. which is move volatility and i would argue this is what the treasury is focused on very clearly is what they really want is a stable funding environment because they've got a role ultimately or refinance ultimately 40 trillion in outstanding debt obviously not at once but the burdens are clearly growing and you're looking at very very big weekly auctions potentially upcoming. Now, what this is telling us is the volatility across the yield curve or term structure in the US. And the move index is basically rather like the VIX index for equities. But this is measuring bond market volatility. And what I try and show there is it seems to be a deliberate attempt to move that move index, so to speak, back into its normal zone. And the Treasury does that through a variety of mechanisms, one being increased issuance of bills. So they're starving the market of coupon issuance. And the second thing is to do these Treasury buybacks. Now, my interpretation of the Treasury buyback program is it's nothing to do with trying to get yields down or certainly not directly. I don't think Scott Besson being an experienced market operator would be as naive as to think that he'd get away with that. What he's actually trying to do is to reduce volatility. And he's doing that often quite successfully, managing to buy, in some cases, retire off-the-run bonds at $0.60 in the dollar, which is a great win for US taxpayers. So I think that he comes into a lot of bad press. But I think ultimately, what's going on here is a very sensible policy. They're capping volatility in the market. These are the key collateral markets. And they're basically giving the system what liquidity they need in the repo markets. And if you've got a repo collateral market, you're going to be able to get a lot of liquidity in the repo markets. And if you've got a repo collateral system that is the heart of financing, that's exactly what you need to do. And so what I would argue is that beneath the surface, there's a much more subtle policy that is going on at the Federal Reserve. And Kevin Walsh basically, I think, was trying to say that in the meeting yesterday. He wasn't particularly clear. But I think that goes back to the famous Greenspan line of whenever that was, was it 87, when he said, if I seem unduly clear, you must have misunderstood what I was saying. And I think that you can attribute that to maybe Kevin Walsh yesterday, because it wasn't entirely clear. But I think really between the lines, he's talking about this sort of new monetary medicine that has been administered. And I think that's basically this sort of three-legged stool. You set policy rates, you target money market liquidity, and you try and reduce bond market volatility. I think all those three factors are key measures of what the Fed is doing. And I think that's basically what I would argue. So we'll get into the Treasury
Speaker 1in a moment. But just sticking with the Fed, how have you interpreted the reserve management purchases from the Fed, which I believe were at $40 billion, and then they said $25 billion, $10 billion, like injecting new liquidity in the markets to prevent the stress that you were referencing. And now I don't think they're doing anything. So what's your current read of current Fed liquidity? And why is it that the market needed $40 billion per month a year ago, but now the market's fine with zero?
Speaker 2Well, a lot of it was broadly seasonal. I mean, it's R&P have picked up a little bit since again. But, you know, I would imagine that that's going to be something that would change in tempo. And if there are shortages, I mean, let's see what they do. But my contention would be is they've got certainly one eye on the stability of the repo markets. And they don't want another 25. And everything I see them doing is actually trying to manage stability in those markets. And those are really key for not just refinancing the debt, but also underpinning the program that I've tried to explain through this sort of term, Treasury QE. And I think that what you've got as a deliberate shift from what people would have previously characterized as Fed QE, which is an abundant regime in the banks, where the Federal Reserve just basically pumps QE into the system, to shift away from that, which was an abundant reserve backdrop, to what you may call a more subtle ample reserve framework, where they're giving enough liquidity to the financial markets, not a lot more. They're keeping things stable. But that stability lends itself to this additional program, which is clearly fueling federal debt, which is Treasury QE. And this really fits in with the idea that Besson said, Wall Street's had its sort of day in the sun. It's now Main Street's turn. We want to try and boost Main Street. And what you've seen is a very significant increase in what I call Treasury QE. For the record, this is looking at the impulse that is coming from either the Federal Reserve or the Treasury through these various mechanisms. Now, Treasury QE is basically the liquidity equivalent effect of the Treasury QE. And that's changing the mix of debt that is being issued by the Treasury. And the reason that that is an important factor to think about is that liquidity is broadly equal to assets divided by their average duration. So if you think about what the Treasury is doing, it's, first of all, increasing private sector assets by issuing debt to the private sector. But what's more, it's issuing that debt at much, much shorter maturities. So what you've got is, the ratio of assets in the private sector to average duration, basically rising quite strongly. And that's the equivalent of a liquidity impulse. So what I've shown on this chart is conventional Fed QE, which is clearly, by definition, a straight liquidity injection into the private sector. I've split that Fed QE into conventional, which is balance sheet expansion. What I also term not QE QE, which is sort of a more subtle thing of saying there are various programs on the Fed balance sheet expansion. And I've also termed it not QE QE, which is sort of a more subtle thing of saying there are various programs on the Fed balance sheet that are more liquidity creating than others. So let's separate those out. And then the Treasury QE, which is changing the mix of issuance, which is the black line. And if you look at those scale, those programs, what you can see is that basically the Fed QE becomes de minimis over time. And in looking into 27, it basically almost disappears, but it's still there, but in small size. Whereas Treasury QE becomes the it's that which is really driving the real economy and explaining in many cases why you've got very strong nominal growth in US GDP right now.
Speaker 1And so that what you call Treasury QE is the Treasury issuing shorter term debt, Treasury bills rather than Treasury notes, coupons, longer term debt, or a higher ratio of shorter term debt. Tell us exactly what Besant has done and what the numbers indicate. There as well as his willingness to continue doing this policy.
Speaker 2Well, I think that my view would be that what they're trying to do here, and this clearly flies in the face of Scott Besant's original criticisms of Janet Yellen two or three years ago, when she was doing it, he's copying the policy, not least because he can, not least because it's quite effective. And by the way, other governments are also following this model as well of doing a lot of issuance at the front end. Now, basically, if you put that down, you're trying to explain what that means in sort of hard numbers. Currently, bills, Treasury bills, very short dated federal debt account for about 23% of total federal debt outstanding. I think that's going to be pushed up to 30. That's not the highest it's ever been. It's been a lot higher in the past. But let's say 30 is a target. And so I would characterize as sort of the Besant policy headline, not just as 333, if you remember, but much more 333. And I think 30, which is the target level, maybe the target level for bill issuance is where they're heading. And to put that in context, if you think about this Treasury QE impulse, something like a five percentage point increase in the share of bills in total debt outstanding, we reckon is the equivalent of about $3 trillion of net liquidity stimulus. So these are $3 trillion. These are big
Speaker 1numbers, but not enough. It's not liquidity enhancing enough for you and your model.
Speaker 2Well, I mean, let's be clear about this. This is money that's going into the real economy, not money that's going into financial markets. And what I do is I separate out those two aspects. And I think that's an important debate right now to have as to what's happening in the economy. Because a lot of these things are kind of difficult to understand, because people tend to think that you've got one pot of money, and don't really discriminate between the two. It's going to move on. A chart which hopefully explains that, which is this one. And what this chart basically tells us is there is a pool of money in financial markets, which I measure by the red line, the liquidity cycle. So global liquidity, for my definition, is money in financial markets. And the yellow line that you see shadowing behind that, a step out of sequence, is money that's in the real economy. Now, all money that's anywhere must be somewhere. So if it's in the real economy, it's not in financial markets. And if it's in financial markets, it's not in the real economy. And what you see is a sort of seesaw effect. So basically, what this chart is telling is that the liquidity cycle is a cycle. But often when that liquidity cycle goes down, the money that's in the real economy is going up. So money is being crowded out or sucked out of financial markets by a strong real economy. And I'll come on to the red dots there because they refer to yield curve inflection points. But I think that's a very good reference at some stage. But what this is basically saying is that as the liquidity cycle falls, what you're getting is more and more evidence that the real economy is really going, is really hotting up. And that's what I think the story really is. It's not so much the Fed is tightening and causing that red line to come down, rather the contrary in the last few weeks. What's actually happening is a strong real economy is crowding out financial markets, financial liquidity. Now, I can hopefully show that here, which is looking at the actual data. This actual data is for the world, not for the US, but clearly the US. And what it illustrates is my estimates of liquidity flowing through financial markets, which is the orange line. The black line is the world business cycle, which is purely an aggregation of all the key business surveys worldwide from the US ISM through to the Japanese Tanken survey weighted by GDP and basically shown there as the black line. Now, I've cheated a tad, but not much by just shifting. The black line slightly, but by a few months, but you get the idea that what that's really trying to show is that those cycles are pretty much entirely out of step. So when you get very strong liquidity, it often coincides with economic recession or very, very weak growth and equally vice versa. So what we're looking at in the markets right now is very, very consistent with a late cycle period where the real economy is picking up and when financial liquidity is going down. And what you would expect to see, and I sort of foreshadowed this, I think, a little bit later, too, if you look at what the yield curves are saying, I think this is an important consideration because the one consensus view in January of this year, or one of the consensus view, but particularly strong one, were that yield curves were going to steepen worldwide. And actually, they've flattened. What it illustrates is that movements in US domestic liquidity basically precede, by around nine months, changes in the slope of the Treasury yield curve. Now, what I've used is the average slope. So this is the area under the yield curve without necessarily looking at any particular spread like 10.2 or 5.10 or whatever, but this gives the average. But what it seems to show is unambiguously a strong correlation between these two series. So as liquidity comes down, you would expect the yield curve to flatten. Now, that's an important consideration once you start to factor in a lot of the wilder assertions that are coming out of the media about what's going on in the bond markets. And what's going on in the bond market is actually absolutely normal. This is a very, very normal bond market cycle. And you can see evidence. This is looking at daily data for the 10.5 yield curve spread in the US. But again, what you see is from the beginning of this year, there's been unnoticeable flattening. And the dominant part of the 5.10 spread, is term premium. So you've actually got here declining term premium. Now, the head scratching point is that if you've got declining term premium, which is what I argue is going on, and not just in the US, but increasingly worldwide, that tells us there is an increasing demand for safety of safe assets in the system. Now, this may be the beginnings of that, but I think you can see evidence of it. What's more, it flies in the face of all those media comments that say, the reason that bond yields are going up is all because people are scared about the fragility of fiscal finances, concerned about debt, worried about Besant, or frightened by Trump. And this is simply not the case. What's happening is something very, very different. The yield curve is flattening in the US, and it's flattening here in Japan. And look at what's happening in the JGB 10.2 curve.
Speaker 1Right, Michael, just to explain. So the media, and I'll include myself in the media, there's a narrative in the media, that the reason that long-term government bond yields are surging are about worries about fiscal sustainability, as well as the ability of central banks to control inflation. So that would lead to a steeper yield curve. And yes, maybe the two-year would go up, but the 10-year and the 30-year would go up the most, because that is where the concentration of the concern is. But your work shows that actually the two-year and the five-year have gone up more than the 10-year and the 30-year. The market is just worried about inflation, and it's pricing in that central banks are going to have to tighten interest rates sufficiently to fight that inflation.
Speaker 2I think what they're saying is that the fact is that if there was a major inflation concern, you'd expect the yield curve to be steepening, and it's not. It's going the other way. And basically, what's driving the yield curve is if you dig deeply into it, is its term premium, one of the main factors coming down. And this is true, in terms of Japan as well. I can evidence what's happening to term premium. And this is my estimates of term premium daily from the beginning of 2025 across all the major markets. Now, even if you look closely at that top red dotted line, which is the French oat market, that's been one of the most elevated, clearly because there is concern in France about fiscal fragility, which I go along with. But that's not worsening. It's basically going sideways to coming down. The three big markets at the bottom, which are the German Bund market, the US Treasury market, and the Chinese government bond market, basically have seen their term premium flatline to shrink through this year. What you're seeing is, I think, evidence that there is an increasing demand for safety in the system. And what's driving bond yields is much more nominal GDP. So it's rate expectations that are really pushing things up. It's not the term premium element in the bond market. Now, if this chart explains that, or hopefully does explain it, this is showing nominal GDP growth, which is shown as the black line, which is the underlying four-year average of NGDP in the US. And the orange line is risk-adjusted. In other words, Treasury 10-year yields taking off the term premium. So this is the average interest rate, policy rate that's expected over that period. And you can argue that those two numbers align pretty well, certainly since the 1951 Treasury-Fed accord, when basically the Fed became more independent. And you can see that what that would suggest is that you're moving up to test 6% or thereabouts in terms of Treasury yields. Now, what's the reason for that? The reason is not because of fiscal fragility, or whatever else it is. It's purely because of strong economic growth. And what you can see on the black line is the fastest rate of NGDP growth since the mid-1980s. Now, it may not feel like that, but that's what the data is telling us. And that's because you've got an inflation element in there. This is not denying the fact that you've got a K-shaped economy everywhere, but certain elements of that growth are being driven by things like fiscal spending, big deficit, as we know, and the AI cap expand, which has been largely responsible for about a third of that growth over the last few years. So, you know, you've got factors which are pulling the economy up, but they're also increasing financing demands.
Speaker 1So you're projecting the risk-adjusted 10-year yield to continue to go up?
Speaker 2Well, no, I think it's about pretty much where it is. And I think that if you factored in my estimates, which are not the same as many others, but I mean, I do term premium calculations differently. But if you look at that chart, you'd see that my calculations are suggesting that the term premium on the US treasury market is about negative 50 basis points. So if you add that to that, you're looking at a target rate of somewhere between five and a half and six for the 10-year treasury, which is pretty much where it's got to. But I would think that's a decent fair value for it right now.
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Speaker 2Well, I think the first thing to say is let's put this in context. So this is using Bank of England US Treasury data. This data, which I pulled from their website, basically shows data on British Consul yields going back to 1700. And I've spliced that with US Treasury data, I think started in the 1830s. So what this basically shows is the long term, a hybrid long term US UK interest rate. Now, if you look at that data very closely, you'll probably see there are something like 70, 70 year cycles in that. But broadly speaking, when we got to in the post GFC COVID years, and I think the low point on that chart is 2021. If I remember, when we got down to, you know, whatever it was a half percent on Treasury yields or thereabouts, that was clearly a novelist figure, but it's just crazy numbers. And I think I've probably said this before, but when I was at Salomon Brothers, the book that we were sort of schooled on was a history of the US Treasury. And I think that's what we're looking at. And I think that's a history of the US Treasury. And I think that's a history of interest rates by Sydney Homer. And that looks at 5000 years of interest rate history, a great call for insomnia, but nonetheless, it's factual. And what that shows is no evidence at all of those low, ultra low or negative interest rates. This is an anomaly in world history. And what it's done is caused this disruption in the bond markets and in the debt markets. But where we are now is we're back above the long term average just and so it's actually worth it. And I think that's a history about putting bonds in your portfolio for the first time in a long, long time. And what I would say is that bonds are behaving pretty normally. Now, if I come back to this chart, this is looking at what happens to yield curves. And what I would venture is that what you're looking at in markets right now is a very, very normal bond market cycle. And I tend to think of it in terms of the liquidity phases and the slope of the yield curve. But this is basically telling you what's going on. So if you look at the four quadrants, you'll see that the bond market cycle is very, very normal. And I the top left is my rebound phase, which is early cycle upswing. Calm is when you're above average and rising in terms of liquidity. Speculation is the late cycle phase that we've been in for much of the last 12 months. And turbulence is what we're coming into. Now, if you look at that movement, it correlates with the economic cycle shown in the middle, recession, recovery, boom, slowing growth. So speculation, it aligns with boom. And that's what you normally see, a bear flattening of the curve. And that's exactly what we've been seeing through this year. It's been a speculative type market. And the bond markets have really judged that correctly. Prior to that, we had this bear steepening in the curve, which was up until late last year. And that's given way to the bear flattening. And the next phase up, it typically is a turbulence phase on the bottom left, which is when you start to get a bull flattening in the curve, when longer rates start to come down. Now, I'm not hopeful we're going to get big drops in yields like we saw during the COVID years, but I think we will see some attenuation. And part of the reason for that is that everything is cyclical. Despite the fact we all agree that maybe there are some compelling long-term trends in terms of monetization of debt, which is something we've got to bear in mind, on top of that, embroidered on top, are very clear cycles. And we've got to be cognizant of those cycles, because that often destroys the sort of trend investing that many people are doing. We've got to understand that process. And I think we're coming to that junction now, where we're looking at this downturn. I think the Fed is trying to, maybe trying to understand that, maybe trying to fight that. Whether they do that, I'm not so sure, whether they succeed. But the fact is that the downswing is what we've got to face up to. And in that environment, you want defensive assets. And if you come back to the asset allocation, diagram, this is what we always recommend investors do in different phases of the market. And this doesn't change from cycle to cycle. It's pretty much embedded. But what you can see there is a traffic light, if you like, of assets on the left. So these are traffic lights that refer to what you should do in different environments. So red is stop, green is go, amber is proceed with caution. On that basis, if you're going to do that, you've got to be cognizant of that. And I think the Fed is trying to do that. And I think if we're moving into turbulence, I mean, the only asset class that looks a decent one is longer duration government debt. And equally, if you start to look at the industry groups, you want defensive stocks. Now, it's very interesting, I think, is if you start to look at some, you know, what's leading the boards in terms of momentum, it's things like healthcare. Energy is clearly been up there through this year. Consumer staples are getting a bid. You're getting things like Russell 2000 being very weak. You know, tech is well, let's say best mixed. So you sort of get the idea that maybe we're rotating in the markets and the level may be still elevated of the indexes, but there's a lot of vicious rotation going on beneath the surface. And in my view, if you look at the credit markets, credit's really starting to feel the icy winds of slower liquidity right now.
Speaker 1It absolutely is. You're having high yield bonds, unsecured bonds like CoreWeave. Their spread is absolutely blew out in October. And Michael, completely with the Russell 2000 small cap index, it has just such a massively positive correlation with short-term interest rates. I just track it every day on the market pricing the Fed to be hawkish. So two-year went up and the Russell went down. It really is just a massively positive correlation. So Michael, the consequences of us being in a speculation phase, advancing towards a turbulence phase and how that is a scenario for a potential bull steepening. So long-term rates are going to be very, very high. And I think that's going to help us understand how is Warsh going to be dovish if the price of oil is at a hundred bucks or even higher and nominal GDP growth is just so high. Does the economy have to slow down?
Speaker 2Number one is to say that the way to judge Fed policy is not purely through Fed funds. And that's probably the main point I'm trying to argue here is you've got to look at a range of different indicators about what the Fed is doing. I don't think the Fed wants to tighten. I think the Fed may need to tighten. Again, in terms of at least the dimension of higher Fed funds if you get continued economic momentum. But what I would argue is that the seeds are already being sown for a slower economy next year. And there's maybe a way I can try and articulate that with another couple of charts, basically to say, look, this is the US dollar. This is the DXY. This is purely a chart of the dollar. Okay. Trade weighted dollar. And you can see that what the dollar is, what it's been doing, certainly in terms of the way that I've drawn the trend lines, is it's been trending higher. Okay. It may be hitting the top of that, but we've had a stronger dollar. We've also had oil prices that have gone up. And one of the things that I argued fairly strongly at the beginning of the year was that if gold price is gone up as much as they had, you will likely to see very strong gains in commodity markets this year. And you would see strong gains in oil. And I think you're getting that, but you're getting it mostly through product prices. And if you look at the orange line on that chart, what I've done is I've bootstrapped a crude price from diesel prices. So the equivalent oil price looking at diesel is over $160 a barrel. That clearly impinges on the economy. And another indicator that you might look at is looking at volatility in the bond market itself tends to be not a bad indicator of future economic growth. And what I've done is look at the move inverted here, against the US ISM. So if you've got heightened bond volatility, which is clearly that's jumped up lately, you've got a stronger dollar and you've got higher oil prices, put those indicators together, those three, and do a Z score of them, which I've done in orange. So this is purely a Z score of those three factors put on top of the world economy. And what you find is that it seems to match, not a bad fit for what happens in terms of business cycle. Now, if that's correct, what we're seeing is a surge in economic growth now, and that will be the black lines already probably moving a lot higher. But then you start to see an inflection in quite a vicious one in 2027. And if you add to that fact, the fiscal stimulus is probably waning a bit. The AI capex boom, who knows, but that may be compromised by higher rates itself. You could be seeing a slower economy, and that would facilitate chairwash basically moving to an easy attack. And I think that's the way you get there. But the bond markets always get there first. And that's pretty much what the bond markets are telling us is going on.
Speaker 1So Michael, as long as I've been following your work, I don't think you've ever been worried about a recession or had fears about a recession that were greater than the market. Certainly, the market was worried about a recession in 2022 and 2023. And you defiantly were saying, no, the economy is going to be strong because of your liquidity readings. As well as other work you've done. Are you now saying that your concern about an economic slowdown and a potential recession is higher than what is implied by financial markets?
Speaker 2Well, I mean, I'm not saying recession, but I think that we always dance around the head of a pin about probabilities. But clearly, the probability has increased. My best guess would see a slowdown and maybe a noticeable slowdown of the sort of pace of economic growth right now. And I think that's the factor which basically enables the Federal Reserve to move to maybe a more benign tack. But I still say right up front, I don't think this is a Fed that wants to tighten anyway. I think if you look back at the track record, the focus is much more on the stability of the treasury market. And that's really the key policy priority. And after all, the cynic in me says, look, it's been six years, almost six years since they hit their 2% inflation target. Chairworship, they're doubling down on that. But I can't really see the evidence if they were doubling down on that or raised interest rates yesterday. And they didn't.
Speaker 1What do you make of Kevin Warsh and the Fed? I think it's a good question. And the differences in his leadership style and how his different philosophy is impacting the actions of the Federal Reserve, both for rates as well as balance sheet and liquidity.
Speaker 2Well, I think in terms of maybe I've just sort of foreshadowed at the beginning, I think if there's a parallel, it's much more Greenspan-like and certainly his utterances are more Greenspan-like. So I think that that's one marker. I think that in terms of what he's really saying is a step back. I always thought he was put in to the Fed anyway, not necessarily to cut rates, but to keep rates as near where they were as possible. And I think he's more as fulfilling that role. The whole emphasis is that the Fed is working a lot more closely with the Treasury. Besant and Warsh are a sort of couple here. And what they're doing is they're trying together to maintain the stability of the Treasury market. And at the end of the day, this is really the key criteria. It's not only Congress gives the Fed two mandates for sure, but it says they've got to operate within those mandates. And I think that's a good point. It's within a framework of Treasury market stability. And I think that's the number one priority, given the backdrop of this huge debt mountain that we've got to refinance, you know, 40 trillion and growing. And that's just the federal debt backdrop. Now, just look for evidence as to what happened in Britain when you got this Liz Truss moment. The Bank of England switched from QT to QE overnight. And you can see this so evident among central banks. And that's what they'll do. I mean, look at what they're doing. They're going to do a lot of things. What's going on in France and Europe at the moment? And we haven't covered Europe. And I mean, there may be some interesting comments to make about what Europe looks like next year. But the fact is that the ECB were all too willing to argue that they would be there backstopping any significant widening in spreads that were occurring in the euro system as a result of this sort of French debacle. They will use their TPI program, I'm sure, if need be. They don't need to do it yet. There's not the sort of degree of stress as we speak in the markets, but they will. And I think this shows what central banks are trying to do or policymakers in general are trying to do. They don't want to tighten. Any thought of austerity is just not there anymore. And what you've got is to sort of take the sort of bigger picture. I mean, we're in a world I've described as being capital wars, where effectively the West or more particularly the US is in a struggle against China. And it's inconvenient to have disruptive financial markets and recessions. That's not what the name of the game is. We need to push forward with the development of strategic industries. And that's why this Treasury QE is so important. And what's more, if the Treasury QE is important, then the integrity of funding via the Treasury market is absolutely crucial. And that's what I think the name of the game is.
Speaker 1Michael, earlier you said that there's a difference between Treasury yields going up and the Treasury volatility. So Besson wouldn't mind if yields went up. He just doesn't want them to go up in a disorderly way. And I understand your point. But to me, they seem quite correlated. Like if there's a crash in bond prices and a crash up in yields, it probably will be extremely disorderly. So you don't think that Besson is trying to cap longer term interest rates by doing the enhanced Treasury buyback program? And also, how significant in your calculus is this Treasury buyback program of Yellen starting? I think there's a number of ways to address that. I mean, the first thing
Speaker 2to say is that if you look at Treasury yields and volatility, there's not a great correlation between them. So they're separate factors. Despite the fact that I take your point that intuitively you think there'll be a closer connection. Basically, Treasury volatility is important because it affects what I call the collateral multiplier in the system, which is basically saying how many times can you leverage or how efficiently can you leverage collateral? And if you get a lot of volatility in the collateral base, in other words, in the Treasury market, your ability to leverage is compromised. And it's very clear that that has a negative liquidity effect on the system. So what they want is to minimize volatility and try and have collateral used as efficiently as possible. And I think that's a key consideration. How they do that is they're going to have to do that is, in my view, by putting more bills into the system. Bills are obviously, by definition, less volatile than coupons, particularly if you move out to longer durations. And secondly, they're doing it through buybacks. Now, I think it would be, you know, I don't think Scott Besson is as naive as to think that doing a $6 billion buyback program is in any way going to influence yields on a $40 trillion market, okay? Particularly when he's, you know, he's focused on retiring off the run Treasuries. So that's not the issue. I think what he can control is volatility. And, you know, I know this is not perfect, but I mean, one of the things I've been trying to do over the last few months is to correlate movements in buyback announcements with changes in the move index. And there's certainly some degree of correlation. And it basically says, whenever you get a spike in the move, what you find is that buybacks seem to go up. So I think there is this linkage.
Speaker 1You approve of their actions, but you do acknowledge that the results have been mixed, certainly with, I mean, we did have a historic bond crash in September. Well, yeah, but I
Speaker 2mean, I think they, again, I wouldn't say a bond crash. I mean, I think the thing is that they can't control. I mean, I don't believe that they have got any expectation about controlling the level of yields. I mean, this is not like previous Feds where they thought, you know, going back to the famous conundrum, where if the Fed changed interest rates, the Federal Reserve was puzzled as to why the long end of the market moved the other way. I think they've moved on from that. And they now realize that the market is really very much in control. I mean, in fact, Walsh said that yesterday. He said, you know, we're not controlling those interest rates. I think that that's pretty clear they're not. They can encourage the right sort of backdrop for the markets to operate, which is a liquid market, and a liquid market, both from the perspective of having sufficient funds there in the repo markets, and being liquid enough at the longer end, so you don't get too many off the run treasuries. That makes sense.
Speaker 1So Michael, I think you've made quite clear your outlook of the Treasury policy to be quite accommodative in 2027. You're forward looking, looking at the going back to the Federal Reserve balance sheet. It certainly is no secret that Fed Chair Kevin Walsh was in his statements before he had any power. And it was just, you know, a commentator that he was extremely hawkish on the balance sheet. He did not think it was appropriate for the Fed to be able to have a large balance sheet. And as such, you know, one expected that the balance sheet could decline severely once he is in power. He set up all these task forces this year. What is your expectation of what those task forces might say, and the degree to which the Fed is going to implement them and what the Fed might do for its balance sheet? You know, is it going to just do runoff? Is it going to be an active seller of securities? Is it going to be doing more RMPs, or is it going to be doing more RMPs? And what are the broader consequences that you expect on the broader liquidity conditions over the next few years?
Speaker 2Well, I think the way that I see it is very clear in the sense that if you've got a rising debt pool, which you clearly have, I mean, every country has, you've got to have an increasingly large central bank balance sheet to manage that. And, you know, it's purely fanciful to say that we want a radically smaller Fed balance sheet. I think you can argue that you want a smaller Fed balance sheet to manage that. And, you know, it's purely fanciful to say a smaller Fed footprint in the markets. And that's not inconsistent in the sense that you don't want to do forward guidance. You don't want everyone sort of, you know, you want the Fed to surprise at certain times. I think I get all that. But I think in terms of managing debt markets, which is sort of the crucial thing, you need to have that balance sheet capacity. You need the ability for the Federal Reserve to move in size. And therefore, you need that potential balance sheet capacity. So shrinking the Fed balance sheet, I just think is a no-no. I can't see how they could do it. And the last time I was in the Fed, I was in the Fed balance sheet. I was in the Fed balance sheet. And they tried tentatively to do that back in Q4 of last year. And what you basically saw there was a big sell-off in the repo markets. And that's, you know, that's clearly a
Speaker 1problem. So do you expect the Federal Reserve to be a seller of securities to reduce its balance sheet? Or is it merely going to do the far less hawkish thing and just say, oh, we're actually just going to roll it off, which could take a ridiculously long period of time and isn't that hawkish? Well, I don't think so.
Speaker 2I mean, my view is they're going to do it. And I think that's There'll be accumulating securities, not selling them. I mean, the balance sheet will be bigger. by 2030 than it is now. And I think the task force will basically come down with that view.
Speaker 1Really? So you think that the task force is going to say, actually, we need a big balance sheet. We're going to do QE again?
Speaker 2I think they will not. I mean, okay, there are two statements there. Are we going to do QE again? I think that they would do, I mean, in my terms, yes. But I think that publicly, they would never admit they're going to do QE again. I mean, it'll be buried in terms of some other acronym. For sure. Do they want to, will they sanction a larger balance sheet? I would think yes, because I think the fact is that, you know, you look at how much debt has gone up since the GFC, the stock of treasury debt, and basically you need the Federal Reserve to grow in parallel to that. The Fed balance sheet has got to move para-pursue with the increase in debt, in my view. Otherwise, it becomes unmanageable. You need that capacity. And what I've argued the whole time is that the ratio between debt and liquidity is crucial. And what's in particular crucial within the crucial bid is that federal debt and Federal Reserve balance sheet are key components of the debt and the liquidity parts of that quotient. So you need the two to grow together. Otherwise, you'll get problems. You'll get clear refinancing problems.
Speaker 1Yes. And the reason that there's refinancing issues and that there's a squeeze, such as we said, we saw in September 2019, is because banks demand so many reserves for a variety of reasons. And so if the Fed actually wants to reduce the Fed's balance sheet, they have to reduce the demand for reserves. And Daryl Duffy, professor of Stanford, had a paper on this and their four mechanisms. So I interviewed him. So people should check that out if they want more interest. Michael, I want to get into your implications of your liquidity cycle view and all of this on asset markets. But before I do, tell us about the capital war substack and the work that you do and what clients get there.
Speaker 2The capital war substack is basically a way of expressing these views. The term capital wars came from a book I wrote about five years ago, which was really arguing that the dominant trends in the world economy were moving towards this sort of conflict between the US and China and how it would exercise itself around the control of financial markets and currency. And you would see the increasing polarization towards the dollar area and a yuan base. And you'd see the rise in the US dollar area and the rise in the US dollar area. And a lot of the thinking comes around that. So it's about control of liquidity and capital flow. And that particular substack, again, as I say, stress called capital wars, provides both data and narrative for investors. It's written in not too complicated a way. It's supposed to be clear in terms of what the messages are. We give advice on asset allocation and also describe what's going on in financial markets. So there are basically at least three pieces a week, one data-orientated and two more narrative about what's going on. We include analysis of Bitcoin and bond markets and the economic cycle.
Speaker 1So it's an analysis of liquidity through the lens of what we're talking about from policy, but also collateral values, the dollar, oil, and how that impacts liquidity conditions. Monetary Matters can get a 20% discount on an annual subscription by clicking a link in the description. Michael, now let's talk about asset markets. So what is your impact on risk assets right now? Stocks, gold, Bitcoin, and how is that being shaped by your liquidity framework and what we've been talking about so far? -
Speaker 2Okay, well, if we go back to the diagram we had, so this is how we envision the world unfolding. You have a liquidity cycle shown in red and in orange, we show there basically the economic cycle shadowing that. That is a sequential process, and you'll see there are four different phases that we identify there in terms of investment regimes, turbulence, rebound, calm, speculation. That identifies with this asset allocation traffic light that we looked at before. And as we shift between the regimes, the bias towards various areas changes, and that's what we try and articulate. So we've been arguably in the speculation area this year. It shows that the areas that we were emphasizing and not, we did not get the technology lift off in Q2 or whenever correct. Technology has surprised us by having that sort of second surge, but nonetheless, I think a lot of other things have been correct, not least the big ramp in commodity prices this year and the recent failing of credit. So that's how we tend to look at the world. And if you want sort of further insight as to maybe what's going on, let me just illustrate some of the other points. This is what's happening to credit spreads right now. So we are not in credit right now. We think the credit may be worth picking up as we move through this turbulence phase, if yields start to move up appreciably more. So we'd be looking to buy, but we're certainly not there yet. We're more in net seller of the credit space still. And you can see here, the orange line, which is showing the junk versus high yield spread. And then the black line, which is looking at a hybrid average for corporate spreads, corporate yields against five-year treasury yields. So both are sort of looking a little bit exercised now. This is looking at the CRB commodity index and the world business cycle to show what you've seen this year as a phenomenal increase in commodity markets, pretty much consistent with that economic tempo. So this is, this is the real economy element. And not surprisingly, you should have also seen strong growth in earnings. And this is looking at the ISM and US reported earnings growth in the S&P. So you've seen this sort of cyclical background unfolding. So we would be arguing now, if you look into 2027, that the economy will cool to some extent, and that black line would ultimately, maybe it's moves up a little bit more in the next few months, but it begins to roll over again as we move into 2027. So that would be a warning for looking at the equity markets. This is looking at what's been going on in equities from a world perspective. And this is showing the two components of equity market returns, a P/E multiple, which is shown in orange, the change in the P/E multiple I should add, and then the growth in earnings per share, which is shown as the dotted line. I would argue that what's different this time is not the P/E multiple change, that seems to be moving pretty much consistently what you'd expect with falling liquidity and rising bond yields. So P/E multiples are coming down. What is unusual is the strength on the lateness in earnings per share growth, which are coming through much later in the cycle and arguably in bigger size. And that's what's causing equity indexes to hold up. So that may be, as I argue, that may be cracking now. And then looking at the treasury market, where we look at, the two key elements, term premium, which is shown in orange, and the black line is looking at rate expectations in the US, which is trying to understand what the peak terminal policy rate is for the Fed in the curve. But that's basically saying that what's driven bond yields of late has been the black line, not really the orange line. So term premium admittedly been volatile, but the net over the last 12 months have been pretty flat. It's really been rate expectations, keyed off a much stronger economy that have been the key thing. -
Speaker 1So your views on asset markets are broadly in line with the changes from a speculation to a turbulence. So you like cash, you like bonds, you don't like credit, you don't like equities or beta. -
Speaker 2Yeah, I mean, the answer is that in speculation, we're paring down our equities. I mean, we were very positive on commodities through this year. So I think we made a lot more money in commodities than we've missed on by paring back equities. Fixed income, we've been, you know, through speculation, you know, wanting to move there beginning with shorter duration. And now we're starting to move longer duration in some of our bond positioning and beginning to pare down commodities. I mean, commodities shouldn't perform well if this is turbulence. That's another way to look at it. So if you look at commodity markets versus TLT or something, that may be a very good gauge as to what's going on. -
Speaker 1What would it take for you to get bullish on beta and equities again? What would you have to see? -
Speaker 2Without any question, a turn in the liquidity cycle. -
Speaker 1And what would the signs of that be? -
Speaker 2Well, I think it would be, confirmation would be a change in direction of yield curves. So that would more or less confirm that we'd seen something. I think another thing, this is looking at the two year treasury note shown in orange and the black line is SOFA. So that's, I think it's a very good indicator of what's happening. So I've been looking at the chart, and I've been looking at the chart, and I've been looking at the chart, and I've been looking at the chart, if you scale that relative to what happened during the Powell chairmanship of the Fed when Powell tightened through 21-22 you'll see there's a very significant difference and this is why I say that if you look at what the Fed under Kevin Walsh is doing it may be tightening but it's doing it at a much slower pace and I think we've got to remember that this is much gentler in that sense doesn't mean to say that it won't matter but it's not a short sharp sudden burst and everything I see is this is a Fed that's kind of dragging its feet and reluctant to tighten it may still be having to do some more tightening in some avenues but I think that we're yeah we're if you look at that you can say we're sort of late in that period and what we've got to start to anticipate is when you get that inflection now that inflection may well be 27 you've got to start to anticipate is when you get that inflection now that inflection may well be 27 I always penciled in the second half of 2027 for an inflection in the liquidity cycle and that's what the normal tempo would say but it may well be that this occurs sooner given these developments now the other one I'm going to put out which is a lot more controversial is looking at this which is Bitcoin and Bitcoin is an excellent barometer of liquidity okay I think it really pays attention to watch because it's a very important part of the economy and it's a very important part of the economy and it's a very important part of the economy because looking at all the evidence and the statistical work we've done we confirm that Bitcoin is the most liquidity sensitive asset on the planet so it's very sensitive to movements in liquidity and look where you know Bitcoin peaked it peaked shortly after our liquidity cycle basically peaked as well so you got that sudden collapse in Bitcoin and what it's doing now is it's stabilizing now I'm not sure why it's stabilizing but it may be stabilizing but it may be stabilizing. But it may be responding to that flick up in liquidity that you saw from the Fed now I'm not 100% sure that's going to continue but I'm open minded and I am open minded not least because I would venture that in 2027 the economy slows down and therefore the need for a much more aggressive Fed may be mitigated.
Speaker 1By the way Michael your gold and Bitcoin are below where they were when we did our previous interviews over the past year. Whether they were this spring or in October of last year that is interesting obviously we had a huge bull run from October to February 2026 but yeah gold has been trading quite weekly what is your outlook on these sensitive assets gold and Bitcoin right now I understand you're saying that okay they could get some help if the liquidity cycle turns but I mean wouldn't a consequence of where we are in the liquidity cycle by your reading be that it's bearish for gold and Bitcoin. Yeah there's no question.
Speaker 2There's no question about that what I'm saying is that you've got to use those indicators as well as a way of understanding rather better where we are on the cycle so I would envision that you see Bitcoin coming down to test the 70,000 level on this chart that would be my expectation okay where the channels are drawn if it holds that level I think that may be the beginnings of base and that may be telling us that we're a lot nearer. I mean I think we're going to see some sort of lift off the not and therefore you know the next up cycle I think in Bitcoin is going to be significant because it's going to all policymakers are going to throw the towel in they're going to have to there's an awful lot of refinancing to do and I just refer back to this chart which is a scary one and that's a big refinancing demand and they got to print money in some large size ultimately to get through this process and that is going to happen. So this is why you want these monetary inflation hedges the question is timing and we could be dancing on the head of a pin here because at the end of the day if the Bitcoin price triples from here who cares whether it goes back to 70,000 but what I'm trying to say is the information that we get back from the markets looking at how Bitcoin performs is very valuable information I think it's going to drop further now in the indication of this chart channel is that you retest 70,000. But if it holds that's important information and if we maybe turn to gold I'm going to show you my analysis of gold right at the back which is not anything to do with Fed liquidity is all about China and I think the key factor to watch is this one and this is looking at people's bank liquidity and the gold price now I mean this is going down another rabbit hole which is probably too deep to explore but the point here is that if you think that. Debt is a problem for the West and debt has been a problem for countries like Japan debt is a huge huge problem for China and they need to devalue a huge amount of their debt and the only way they can do that is by printing money and I think they've started to do that that's what the evidence shows here the level of PBOC liquidity people's bank liquidity from 2022 to now is virtually doubled that's caused the gold market to go up I don't believe that the gold market has been propelled. By these other elements like Western debasement or the idea of sanctioning Russian gold I think that's the issue the real issue has been Chinese money printing domestically and if you look at what happened this year curiously the peaks in the gold market more or less coincide with when China allowed the PBOC balance sheet to flatline from about February March of this year and that policy may well be tied up with the Iran conflict rather. I'm not sure but it basically seems to attest to that and if you want a more high frequency analysis take a look at that and that's looking at six week changes in PBOC liquidity in the gold price which you know it's sufficiently close to make people think about what's going on yeah your work has been really pressing
Speaker 1on the correlation between Chinese liquidity and the gold price do you have any outlook about where Chinese liquidity is going yeah I think it's going
Speaker 2up because it has to go up. I mean they've got no other choice now they go down the Japan road of two lost decades I mean that's possible but I don't think the Chinese population will accept that because what they want is the PRC to deliver prosperity so I think they're going to have to do something and the experience of every single debt burden throughout history is the only way you get rid of debt in a credit money economy is to devalue it you got no other choice you can't default because that's your collateral. So you basically have to monetize and I think what China is engineering right now as I've described it for is a dual circulation system where they're basically keeping the external the internal values of the yuan different and separate and the internal value of the yuan in other words the purchasing power level of prices and wages are kept very distinct from the external value through capital controls compliance state banks and huge foreign exchange reserves and I think that's how they manage it. And so this work actually
Speaker 1is is bullish gold very very bullish gold very bullish gold
Speaker 2okay so how do you square
Speaker 1your broad liquidity cycle view which is negative for liquidity sensitive assets such as Bitcoin and gold with this Chinese data that's bullish for gold net net how do they balance out.
Speaker 2Let's be clear the Chinese data is not bullish right now because it's going sideways but at least the gold price is holding at the moment around the 4000 mark which is consistent with what that level of Chinese liquidity is. So if Chinese liquidity goes down from here the gold price will go down in my view because I think the Chinese retail is the marginal buyer of gold if Chinese liquidity goes up from here then it'll be very bullish China is a key component of the global liquidity cycle is it likely to move independently of the U.S. it could although all the evidence is through this year that they won't so it may be that the Fed is the key catalyst and then you'll see the Chinese joining in but at some stage. I've got to print money again and you can see that they have done it in the past and I think they're perfectly capable of doing it in the future and why are they doubling down on things like capital controls why they're making it more and more difficult to invest in crypto because they don't want that money leaving China and that's because they're printing a lot of it and that would adversely affect the exchange rate
Speaker 1so so are you more bullish on gold now than you are on Bitcoin and stocks because of this Chinese. I'm more bullish on Bitcoin
Speaker 2and gold than I am on stocks because I think stocks are much more a factor of the liquidity cycle or maybe the mid liquidity cycle and where we will be at best by the middle of next year is in the early cycle phases again which is where Bitcoin and gold tend to move up. Am I bullish more bullish on Bitcoin or more bullish on gold. What I would say is defer the answer by saying I'm bullish on both Bitcoin. Bitcoin is a lot more sensitive to liquidity but we've only had a 10 15 year track record on that so we don't really know whereas we had 5000 years history on gold and if you look at the multipliers in other words the elasticity is relative to a 10% move in liquidity gold is about 15% per 10% rise Bitcoin is about 45 to 50% so the magnitude for Bitcoin is hugely more although that factor is kind of a factor. Bitcoin is a lot more sensitive to liquidity but we've only had a 10 15 year track record on that so we don't really know whereas we had 1000 years history on gold and if you look at the multipliers in other words the magnitude for Bitcoin is hugely more although that factor is kind of a factor. Bitcoin is a lot more sensitive to liquidity but we've only had 1000 years history on gold and if you look at the multipliers in other words the magnitude for Bitcoin is hugely more although that factor is kind of a factor. volatility of each. But given the fact that Bitcoin is increasingly likely to be institutionalized, that volatility may come down and afford a bigger proportion in portfolios.
Speaker 1Michael, earlier, right before you went to the Bitcoin slide, and right before you said this chart may be controversial, you said something about timing. And could you just say that again and share your kind of timing view for 2027 of kind of your framework for when this stuff might happen of the liquidity cycle worsening and then getting better and the corresponding effects on asset prices?
Speaker 2Okay, let me get back to the liquidity cycle. So it's here. The health or the wealth warning with this is that whenever you try and predict liquidity, it's always fraught with problems because you don't really need to, because liquidity itself is a leading indicator. So this is the best way to prove wrong is to try and predict it. So I'm going to tread carefully. But what I would say is that if you look at that sine wave, what the sine wave is telling you is that you would get typically a bottom in that liquidity cycle sometime in the second half of 2027. And that's what it was always foreshadowing. I think that could be brought forward a bit. And it may be that you're seeing the first signs of bottoming out now. If you look historically through that data, you'll see that you never really go straight up. I mean, there are occasions when you might, but you never really go straight up. You do occasionally, but pretty much you sort of chop around for a while, particularly if you're around the mid cycle point, which we are now. So it's quite possible that we sort of remain a bit volatile over the coming months, and then maybe push up through first half of next year. That's possible. But I would expect to see that. Where would you see that first? I would look at Bitcoin as a very good barometer. But just bear in mind, that's not suggesting that you're going to miss the Bitcoin rally. You may miss the first 10% of the Bitcoin rally. You may miss the first 10% of it. But if this thing is going to double or triple, then so what? That doesn't matter. It's a very good guide as to what's happening. And I think with all investment, you need context. And that's what this framework is really designed to do.
Speaker 1And so that nadir, that bottom in liquidity in 2026, or maybe late 2025, of how it just dipped below 30 on the Global Liquidity Index, GLI, and that has since gone up. Do you expect that to be a local bottom and then to further go down? And so the absolute bottom of that chart will be lower? Or do you think we already have reached the actual bottom in the GLI?
Speaker 2Well, I would say with confidence that that line is going to come down again, right? That black line will come down again. Will it go below that 28 reading that we saw before? I'm not sure about that. But I think we're going to dance around these sort of mid-levels. I don't see the case yet for any significant plunge in liquidity, like we saw before, if you go back to 2023, with that big tightening that we got. Clearly, there are challenges out there. Make no mistake that there's a big refinancing burden to come. And it may be that policymakers mess up, say never. But I think that what they need to do, and what history tends to show, is that when you get these big refinancing burdens, they tend to try and push liquidity into the system, because the system needs it. They may misjudge that. They may overreg it, and they may underestimate it. But they'll at least try in directional terms.
Speaker 1Michael, when on this chart is the time that's a bullish sign for risk assets? Do you want to buy it from when it goes from 10 to 80? Do you want to buy it from when it goes from 40 on the upside to 40 on the downside? What exactly is the signal here of interpreting this data for its implications on asset prices?
Speaker 2Okay, well, I'll tell you how we use that. I mean, clearly, if you're looking at single data points, single months, you're going to be precisely wrong. And this is by the nature of the volatility in the data. We'd much prefer to be approximately right than precisely wrong. So what we do is to tend to look at changes maybe over three or six months and use that. So in other words, put a moving average through this data and see when you get a definitive turn. And if you miss the first bit, so what? Not least because it's going to be a little bit less than the first bit. So what we're going to do is we're going to put a moving average through this data. So what we're going to do is we're going to look at the three data points that show a definitive pickup. If that's the case, then the upswing, assuming the upswing then continues, is very bullish for risk assets. Equities tend to do best from the second phase. So the first phase, the rebound phase. So if you look at the calm phase, that's when equity is really doing well. They can do well in rebound as well, but you really want to be, if you look at the beta exposure, you'll sort of proceed with caution in rebound because of the uncertainty about the position in the cycle. And then once you get to calm, it's fall green. And so that would have been, let's say, the rebound phase. Rebound tends to last maybe around about 9-12 months. Calm is reassuringly. Speculation tends to be about 9-12 months. Turbulence is a bit shorter than that, typically. And if you're in the rebound phase, I mean, if you miss the first couple of months, that doesn't matter too much. The whole point is context. And you don't want things like commodities. One of the things that I'm saying, which is a very unappealing recommendation, I suppose, given the fact that in the long term, we're still very bullish on great. But the trouble is that for the next six months, I don't think that's going to be the case. So I wouldn't be exposed to commodities here. I think they're pulling back. And I would be thinking much more of government debt.
Speaker 1So you like long term government bonds. That's very interesting. And you said that the cycle is probably going to bottom in Q2 of 2027. Michael, do you think that what causes the cycle to bottom is kind of a panic among policymakers because to me, the only thing that could cause Kevin Warsh to be like, yes, I am buying government bonds and I'm returning like doing a 2020 all over again would be a financial crisis. And it seems like to me, things would have to get pretty bad to prompt that response. I'm curious your reaction
Speaker 2to that. Well, I can only agree with that. I think that's a fair point. I'm not suggesting that there won't be pain in the next few months. That's for sure. I'm equivocal about that. But I think that we're moving into a phase which is defined, as I say, by turbulence. If you look at the liquidity cycle, it's not every liquidity cycle where you see financial crises. OK. So it's not every downswing where there's a financial crisis. You can get hurt in asset markets in the downswings. But what I'm saying is if you go to this longer term one, it tends to be that the big downswings are longer frequency or more extended. So it's possible that we're moving towards this everything. But I don't think that's the case. I think it's possible that we're moving towards this longer term. But that might not be this cycle. That might be, as you can see there, that might be in the early 2030s by the time you get to that. So there may be one more cycle we go through first. Who knows? But the problem is what I'm trying to articulate there is the problem that we face with this is this is the big debt burden that we've got to get through. And it's not new debt only. It's refinancing existing debt. And that's the key problem. And the fact is that you've got such huge demand for debt. And that's the key being placed on capital markets now. And the little annotation here confirms that you're looking at close to a trillion dollars of hyperscaler debt in each of the next two years. And you've got similar equity funding coming behind it. So I mean, these are big demands on markets. They really are.
Speaker 1And you showed the chart earlier of triple C spreads versus single B. And basically, that spread is widening almost every single day. That line was alarmingly straight.
Speaker 2Yeah. And that there may be specific risk in those triple C issuers. But the point is that the credit market is where you see these tensions emerge first.
Speaker 1Well, Michael, thank you so much. People can find your work on X at Cross Border Cap. And your sub stack is Capital Wars. Monetary Matters listeners for a limited time can get a 20% discount to an annual subscription. Link is in the description. Until next time. Hope you enjoyed that. Want to say a big thank you to today's sponsor Lens, ticker L-E-N-S, the Sarmaya thematic ETF, which gives real asset exposure and the potential to diversify a 60-40 portfolio. Read the prospectus at SarmayaETF.com. Disclosures in the show notes. Thanks for watching.
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