Latest / TFTC: A Bitcoin Podcast / #654: The Fed Has Painted Itself Into a Corner with Michael Howell

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#654: The Fed Has Painted Itself Into a Corner with Michael Howell · TFTC: A Bitcoin Podcast

0:00
Michael Howell, thank you for joining me again. Big day.
0:03
Yeah, big day today. Big day out in Jackson Hole.
0:07
Everybody's waiting with a bated breath to see what Jerome Powell is going to say.
0:12
I was watching. I couldn't sleep this morning.
0:14
I woke up at 3.30 a.m. and just decided to get up and start working.
0:19
And I've been watching CNBC, and it's been funny watching their commentary.
0:22
A lot of back and forth.
0:23
I think considering that this meeting is happening today,
0:28
we'll post this on Monday.
0:30
And so I guess the pressure is on to sort of predict what Jerome Powell is going to do.
0:34
How would you describe his current predicament and what he may or may not do later today?
0:42
Well, I think it's clearly a difficult situation.
0:45
They always say as an old Irish joke that when they say to travelers,
0:50
how do you get from here to Dublin?
0:51
And the answer is, well, if I was going to Dublin, I wouldn't be starting from here.
0:56
And I think that, you know, that's pretty much what I would describe the Fed situation is.
1:01
I mean, Jerome Powell is in a difficult situation given the sort of pushback or aggressive pushback he gets from the administration.
1:09
I mean, that's for sure.
1:11
But I think the other thing is that they kind of painted themselves in a corner a bit.
1:15
I mean, on most counts, rates should be lower than they are.
1:19
I think he finds it difficult now to probably admit that.
1:23
So there is some resistance.
1:25
But I think you can see within the FOMC, there is a growing willingness, I think, to cut
1:31
interest rates.
1:32
I think given what's going on internationally and with rates and maybe as well what's happened
1:37
lately to the dollar, the rally, the weakening in the US economy, I think there's grounds
1:43
for rates to be cut.
1:44
That's for sure.
1:45
I think the more difficult question, which is something I'm sure we're going to
1:49
dig into, is really what happens to the Fed balance sheet, the Fed operating system looking
1:56
out longer term, because they've been promising us some information about the new operating
2:00
procedures of the Fed for a long time now, and nothing's come out. So I kind of expect or maybe
2:08
think that they're going to do something, announce something at Jackson Hole about the new operating
2:13
procedures that they've been talking and thinking about for some time now. That may come out in an
2:18
announcement. But I think the more fundamental question is what happens to liquidity and really
2:24
the size of the balance sheet. And I think that's relevant, given the fact that if you look over the
2:28
first six, seven months of the year, Fed liquidity, the amount of money that the Federal Reserve
2:33
injects into money markets, actually was up $350 billion, even though the overall balance sheet
2:41
itself, the broad balance sheet, fell by about $250 billion. So you've got liquidity and the
2:48
balance sheet going in opposite directions. And that's kind of because there are other ways of
2:54
injecting liquidity into the system, apart from the headline balance sheet number. And that's
3:00
things like the Treasury general account, the reverse repo program, et cetera. And they've been
3:06
actually positively buzzing and actually adding money to markets, which is why risk assets have
3:11
kind of done so well over the last few months. The question is that if the Treasury is insisting
3:16
on rebuilding that account, their account of the Fed, the Treasurer General account,
3:20
which was forcibly run down because of the debt ceiling. If that now is rebuilt in the second
3:25
half of the year, then a lot of liquidity is going to come out of markets. Now, that's what
3:30
investors are fearing. I don't think it's going to come to that because I just don't think they're
3:34
in a position where they can do that. And that's why I say I think the Fed has kind of painted
3:38
itself into a corner a bit here. Yeah. In terms of choreographing or making the market aware,
3:46
of new operations. Can we dive into that in terms of what they may or may not change or what the
3:52
market is looking for them to change? Yeah, I think that a lot of the market talk is really
3:58
about whether they're going to change average inflation targeting to maybe change the nuance
4:04
of that. Could they change the symmetry in that goal that could be done? For example, I think
4:12
that's one of the things that is sort of high on the agenda as a change. There could be more
4:18
technical things about how their operating procedures are changed. I mean, that may be
4:25
necessary. But I would say, you know, one of the things that may come in, and this has been mooted
4:30
in terms of what the Fed has wanted to do, is maybe they're going to announce that they're going to be
4:35
a bigger buyer of treasury bills in the market than they have been. Now, one of the things that
4:41
was suggested or has been suggested in speeches over recent months is that the makeup of the
4:48
Federal Reserve's holdings of government debt, the SOMA account, the so-called SOMA account,
4:54
is generally vested in longer duration treasuries. So things like 10-year notes, for example.
5:00
And that's not really the sort of representative of the average mix of treasury debt out there in
5:08
the market. As you know, there's been a lot of very, very short-term issuance operating,
5:14
particularly under Yellen, but Scott Besson's continued that. And so the Treasury slated to
5:20
issue a lot more bills. Now, on the one hand, that's playing to this whole argument about
5:25
stablecoins being big buyers of Treasuries in the future, and they like bills. Sure, I go along with
5:31
that. But then the Federal Reserve should be matching, if you like, in its SOMA account,
5:36
the average mix of debt in the market. And the moment they're not, their SOMA account is too
5:44
heavily weighted to longer duration debt. So what they may do is reduce the average by buying a lot
5:51
of bills. Now, that would certainly help the fund take pressure off funding, and it will enable the
5:56
market to get more liquidity. In order to do that, they'd have to sort of change the rules a bit
6:02
on what they're talking about in terms of roll-off of debt. So they could say they're going to
6:07
continue rolling off existing Treasury notes, but then they add an addendum to say, okay,
6:14
we're alongside going to build up our holdings of bills. So they could do something like that.
6:19
Nothing's certain, but I would be looking for some subtlety, simply because if you look at the math
6:25
here, if they do rebuild the TGA, we're talking about taking $300 billion to $400 billion out of
6:33
money markets. And I don't think that's a good idea, to be perfectly honest. I think you'll see
6:39
a lot of tensions in markets if that transpires. Yeah. It's fascinating in many regards,
6:47
both on the Fed side and the Treasury side, because Scott percent very publicly when he was
6:53
coming into the administration at the beginning of the year was lambasting Yellen for hammering
6:57
the front end of the yield curve. And I think he's implicitly had to walk that back and just
7:03
action speak louder than words. They're still hammering it. And I think even explicitly over
7:09
the course of the summer, he has admitted that they will still keep issuing bills on the short
7:15
end. And then to your point about the Fed's painted itself in the corner, it seems like
7:21
drums in this position where he doesn't want to seem like he's letting politics influence his
7:26
decisions. But to your point, if you look at all the ways in which they can inject liquidity,
7:31
they're sort of out of arrows in the quiver. I believe reverse repo last I checked is around
7:36
22 billion down from 2 trillion a few years ago. Yeah, it's right down. And, you know,
7:42
there's not much more they can do to be truthful. So, you know, what you're looking at, I mean,
7:48
sort of ironically, is you're shifting really from a regime of Fed QE, or whether it's a hidden QE,
7:57
but the Fed has been the mainstay of liquidity coming into markets. And you're shifting to a
8:02
situation where the Treasury is more and more responsible for, if you like, liquidity easing.
8:09
It's taken on the mantle. Now, whether that is vested in the Treasury because of the
8:14
durations in the Treasury General account, whether it's as well or probably more particularly
8:19
because of just the changes in the average duration of issuance. And this is an important
8:24
point because very generally, I mean, we can think of liquidity as being an asset divided by its
8:31
average duration and think of duration as sort of the maturity of the debt. So if you're issuing
8:37
lots of debt at very short maturity, that quotient, that ratio between the asset size
8:45
or the debt size and its average maturity is going to increase quite dramatically because
8:50
on average, you're issuing, you're replacing a 10-year note, say, with a three-month bill.
8:56
So the liquidity available to the private sector is going to go up enormously.
9:01
Now, that kind of makes a difference as well for a whole lot of reasons.
9:06
I mean, one is that we live in a world now where collateralized lending is absolutely
9:11
critical.
9:12
You know, latest estimates from the World Bank who have dug very deep into this worldwide
9:17
tell us that something like close to 80% of all lending worldwide now is collaterally
9:24
based.
9:24
I mean, that's an astonishingly high figure.
9:27
But that's the reality.
9:28
This is how the world has changed since the global financial crisis.
9:32
Collateral is really critical to the system.
9:34
And so what you've got to have in terms of future liquidity growth, in other words, future lending growth, is a stable collateral base.
9:42
You can't afford to have the bond markets going awry. Now, with that regard, you can help that situation really in two regards.
9:51
One is you can start to issue a lot of very short term paper, in other words, bills.
9:56
Now, I know we accept the fact that this is not sort of great long term planning from the treasurer's perspective.
10:03
And Stanley Druckenmiller has been on record as saying over the years, look, these are the numbers that you'd expect to see, or this is the policy you'd expect to come out of Argentina.
10:12
And we can't really say that about use Argentina as the benchmark anymore.
10:16
But you know what I mean.
10:17
It's a Latin American type funding process to fund at the short end.
10:21
But, you know, hey, the US is now doing that.
10:23
But one of the advantages, if there is an advantage in doing that, is you actually don't absorb liquidity from the market.
10:33
You actually create more liquidity because you're showing a very short-term bill.
10:37
And what's more, you help to contain volatility in the collateral markets.
10:42
Now, that's absolutely critical, and that shouldn't be lost sight of.
10:46
One of the things that we've seen over the last few months, which is a wonkish point, but it's still really important here, is that if you depend on collateral for liquidity and credit growth, what you need is stability in these markets.
11:03
In other words, you want very low volatility.
11:05
And there is a statistic out there that I look at very keenly, which is called the MOVE index, which is a measure of the volatility across the Treasury yield curve.
11:15
So it's bond volatility. And if you look at that index, it's plunged dramatically over the course
11:23
of the last few months. Now, that could be purely coincidental. It could be by accident. I think
11:29
it's being engineered lower. I think the Treasury and the Fed realize that they've got to get
11:33
volatility down. If they get volatility down, that's liquidity enhancing. It's good for financial
11:39
markets. And what's more, it keeps hedge funds in the game of buying treasuries. Because one of the
11:46
things you will recall, Marty, is that foreign buyers have kind of slowed down. They haven't
11:52
reversed, but they've certainly slowed down their buying of US debt. Traditional buyers of debt in
11:59
the US are not really there in size because the yield curve is still quite flat. So there's not
12:05
really the uplift on sort of buying long-term debt and funding it in the short-term markets.
12:10
So they're really dependent on the hedge funds who are doing something very technical called a basis
12:15
trade, which means shorting futures and buying cash bonds. Now, that's at the margin, the big
12:21
buyers of treasuries. And what those hedge funds really require is low volatility in the market.
12:27
So I think there's an awful lot of volatility targeting going on. That's, one would have to
12:32
say a dangerous policy, because it can go wrong at a moment's notice. You can suddenly lose control
12:39
of volatility. Volatility can spike. But it does show that there's, I think, behind the scenes,
12:44
a lot of awareness that liquidity is a critical factor in markets right now.
12:50
Yeah. And your newsletter from yesterday, diving further into this point, I'm going to make
12:56
a question and then actually two questions. First, it's just describing the world collateral
13:02
multiplier, like reducing the volatility of the yields, like gives people more confidence
13:08
and certainty that the bonds, the bonds connected to those yields are good collateral, liquid
13:14
collateral. And then the second question I have is, are you essentially describing yield curve
13:23
control without saying it explicitly? Yeah, I think it is. I mean, it's a form of
13:28
yield curve control. I mean, there's no question about that. I mean, that basically, I mean,
13:32
all these operations are trying to manipulate investors into certain parts of the curve. And
13:39
they don't want long duration yields, in other words, 10-year, 20-year yields to back up very
13:45
much. And then ideally, like investors to be in the front end. And even more, what they'd like is
13:53
J-PAL to cut interest rates. Because if they start cutting rates at the short end of the market,
13:58
the cost of bill finance is going to go right down. And that's going to save the Treasury a
14:04
lot of money in terms of interest payments. So I think absolutely, this is what they want.
14:09
And if they can rational or create shortages of longer-term debt at the long end of the market,
14:17
in other words they going to starve the pension funds and insurance companies with longer duration government bonds then those yields would be down as well So I think there definitely yield curve control Yeah
14:30
And I mean, that's the big question in my mind.
14:33
Once you go down this path, is it complete Japanification of the yield curve?
14:38
And if you look over Japan right now, their 30 and 40-year are breaking away, those yields.
14:43
And is this – they're trying to be as implicit as possible.
14:50
But as you're describing, it gets pretty clear. This is what they want.
14:54
Like, is this a point of no return in terms of driving demand on the longer end of the yield curve from foreign buyers?
15:02
Yeah, I think one's got to put this in context.
15:04
I mean, we're talking here about the US. We're not talking about a Latin American economy.
15:07
And it would take an awful long time for the US to sort of spoil its reputation here.
15:13
The US dollar is still the principal safe asset in the world.
15:18
US Treasurers are still the main, they're pristine collateral.
15:21
It would take a lot to dent that.
15:23
And despite the sort of the media which have been jumping on this ridiculous bandwagon to
15:28
say it's the end of the dollar or it's the end of the Treasury market or whatever, as
15:32
the dollar had a little bit of a wobble earlier on this year, I mean, that clearly is not
15:36
the case.
15:37
But reputation, I mean, the shine can come off reputations.
15:41
I mean, it would take time.
15:42
But I think that you're absolutely right to say, look, we're embarking on a journey here
15:46
and we're treading down a path, and that path is not a very attractive one, because it could end up
15:52
rather like Japan. Japan is now struggling to contain yields along into the market,
15:57
because they've basically been undertaking this yield curve control or manipulation for so long.
16:05
And you can only squeeze a balloon so much until it bursts. And that's the problem that they're
16:12
getting into. Now, I think the US is some years away from that, but I think that you've got to
16:17
be alert to these dangers. And if you look at the pressures on the US Treasury market right now,
16:24
I mean, paradoxically, they're not really coming from domestic largesse right now. They're actually
16:30
coming internationally from pressure on Japanese yields and German yields. So US yields at the long
16:37
end of the market are actually being pulled up by those factors right now. That's not to say
16:41
that there couldn't be a domestic problem upcoming in the next two or three years,
16:46
which would actually push yields up. So I think the danger that we've got here,
16:50
as you rightly point out, is we're sort of moving down a path which is not a very attractive one
16:54
from the perspective of long-term interest rates. And this is the dilemma that everybody faces.
17:01
You know, the US may well be the cleanest shirt in the laundry, but, you know, hey,
17:05
it's in the laundry. A lot of other countries are in a worse shape, we acknowledge, but it's not
17:10
really, you know, to keep saying that we're the cleanest shirt and everyone else is in a worse
17:15
situation is not really great salvation here. The problem is debt and we've got to get off this debt
17:20
problem. And it's not easy. No. And that's like I was describing to you before we hit record.
17:30
I wrote a newsletter this morning, basically just wanted to flag to people. I know everybody's
17:36
focused on what's happening in Jackson Hole right now. But if you look over at the margin
17:43
and leverage in the system, nominally, it's at all time highs. And in real terms, it's right below
17:49
all time highs hit in 2021. And then you consider recent industrial inflation, friends with PPI being
17:58
relatively elevated. You look at the Trump administration and the fact that they are
18:04
obviously looking at this artificial intelligence boom as a national security risk and they want to
18:10
do everything they can to make sure they win the race against china to get the predominant ai
18:17
models in u.s shores or operated by u.s companies and then you look at
18:23
what's happening in jackson hall likelihood of rates coming down being higher than it has been
18:31
in some time.
18:33
And I'm just wondering
18:34
with leverage where it is,
18:35
with markets at all time highs,
18:37
like what does this look like
18:38
moving forward?
18:39
The lower rates go full QE
18:40
with all these other
18:43
external factors playing in,
18:45
particularly with AI
18:47
and the amount of investment
18:49
that's going to be needed
18:50
to build out the energy infrastructure
18:51
to make it possible
18:52
in the first place.
18:54
Yeah, I think these are all
18:55
these are all great points.
18:56
I mean, it puts Jackson Hole
18:57
kind of into perspective
18:58
because there are
18:59
bigger things out there
19:00
that we could
19:00
be alert to. There's a slide that I've given you, you can put up on the screen, which is looking at
19:07
the global liquidity cycle. And that kind of frames the issue that we face. Now, this is
19:14
looking at the world. The index shown is a black line, which is our index of the momentum of
19:21
liquidity through world financial markets. So this is the amount of money. This is not M2 or
19:27
M1 or any of the monetary aggregates. This is money which is flowing through financial markets,
19:32
which is really driving financial asset prices. And what we tried to show there is that there is
19:37
a rhythm, a pretty standard rhythm of about five to six years in that cycle.
19:43
And the sine wave that we've drawn on top of that was actually drawn up 25 years ago in the year
19:50
2000. And we haven't changed it thereafter. It was done by Fourier analysis for those that are
19:56
mathematically inclined. But it's been sort of continued on at the same frequency, which is that
20:01
65-month tempo. And what you've seen over the course of the last cycle movement is that we've
20:09
been absolutely on track. So the cycle bottomed in October of 22, and it's been moving up.
20:15
The volatility you've seen is actually largely a China phenomenon. And I can try and show
20:21
what that looks like if you take a look. Hopefully, that slide has changed to the advanced
20:32
economy stripping out China. And you get a much, much cleaner line. Now, we can drill into what's
20:37
going on in China if you like. But I think the big issue here is that the cycle is basically
20:41
beginning to swing, to turn or get towards the peak. And that's clearly a critical factor.
20:49
Now, if you put that in, as I've shown in this third slide, this is looking at where
20:55
we are against the normal cycle.
20:57
Now, this is not set in stone.
21:00
So we've got to be careful.
21:02
And we're just playing the averages here.
21:03
But the averages are important to watch as a benchmark.
21:06
And that dotted line is the average cycle since 1970, the average liquidity cycle.
21:12
And our view is that liquidity drives markets.
21:15
And so you've got to be aware, alert to this.
21:18
And the red line is the current cycle. Now, we're not turning down yet. That's not the point. Maybe
21:24
we've got a little way to go before we reach the peak. But you can kind of see that, put in context,
21:30
this is the situation that we're trying to grapple with. Now, I put in the earlier slide,
21:36
which was the world one, so adding back China, a projection. And that projection is showing
21:42
that we are reaching a peak, you know, maybe in six months, nine months time, and then we kind of
21:50
go down. And the question is, why do we go down? And that's an important thing to address. So let
21:56
me try and address the reason why we think things may be going down. Now, one of the arguments
22:03
is to look at this slide, which is comparing the current cycle shown in orange here with
22:12
the cycle back in the 1980s. Now, a lot of your viewers probably won't remember the 80s or whatever,
22:19
but that's when I started in financial markets. And I remember the 87 crash all too well.
22:26
I was at Salomon Brothers at the time and witnessed it sort of front on. And basically,
22:31
what you saw was a very similar move to what we're seeing right now. You had a plaza record in 85,
22:41
which was an attempt to get the dollar down. And just think back to the word accord,
22:47
Mar-a-Lago accord. Whenever politicians or policymakers talk of accords, they're talking
22:52
about sizable exchange rate adjustments. And we've had that. That allowed foreign central banks back
23:00
in 85 and again now to ease policy. And that was a factor that drove global equality up.
23:08
It launched a recovery in the world economy, rising commodity prices.
23:12
We're sort of getting that now.
23:14
It began to push yields in bond markets higher.
23:18
We're getting that now.
23:19
And it was ended basically in late 1987 by the Germans saying that they were concerned
23:28
about inflation and they were thinking about and planning to raise interest rates.
23:33
The crash stopped them doing that.
23:35
But that was their intention.
23:37
And because of the Plaza Record and Louvre Accords, there were set, if you like, trading
23:42
bands between currencies and between interest rates.
23:45
So if the Germans moved, the US would have to move.
23:48
And Treasury Secretary Baker at the time was actually much more inclined to want rates
23:53
lower, a little bit like the Treasury and the administration are talking to the Fed now
23:59
get rates down.
24:00
That's what Baker was doing at the time.
24:02
And in the event, things went awry, investors got spooked.
24:08
They realized the liquidity cycle was about to end.
24:11
You can see the dramatic move down in that red line at the time.
24:17
And that's really what happened.
24:19
That caused the crash.
24:21
Now, the orange line is moving up in that direction.
24:25
So your concerns about bubbles and high PEs are very well said,
24:31
because this is what we expect at this stage of the cycle.
24:35
We haven't been there yet.
24:36
We haven't had the trigger, but we're clearly getting late in the cycle.
24:40
And those are things to think about.
24:42
So let's sort of try and articulate why you could be getting this cycle ending sign.
24:48
What I want to do is just to move on, if I can, in this presentation to another slide.
24:56
I'm just going to go through these bits and get to the bit I want to start with.
25:01
which is just here. And that's saying that this is what we've got to think about in terms of
25:07
understanding risk in financial markets. And this is looking at the ratio between debt shown here
25:15
for all advanced economies and the amount of liquidity they've got. So in other words,
25:19
the ratio of debt to liquidity. Now, why is this so critical? The reason it's so critical is that
25:24
debt has to be refinanced. It always has a maturity. So if you issue five-year debt,
25:32
in five years' time, you've got to refinance that debt or pay it back. The spoiler alert is that
25:37
debt's never paid back. It's only ever refinanced. So what you get is a need to refinance periodically.
25:45
And what this chart is basically showing is that ratio between debt and liquidity.
25:49
If you get lots of debt relative to liquidity, you're going to struggle to do the refinancing.
25:55
It's much more of a problem.
25:57
And what I've shown is that when you get above that threshold of about two times of that
26:02
ratio, that dotted line, you get financial crises, which we've annotated there.
26:07
And almost every financial crisis, if you look back, has been a debt refinancing crisis
26:12
in some way.
26:13
And that's important to understand.
26:15
Now, if you look at the other side of that threshold, when you're very low, there's lots
26:21
of liquidity. Liquidity becomes abundant, and its vent is financial assets. It creates asset bubbles.
26:29
Now, if you look at the last five to 10 years, we've labeled that the everything bubble. Why is
26:36
that? It's there because you've got excessive liquidity relative to debt for two reasons.
26:41
I mean, one is that every episode of crises or tension in the world economy, be it COVID
26:47
or be it the GFC, policymakers come in and just throw liquidity at the system.
26:53
They need to stabilize it.
26:55
They don't want the risk of a credit crisis, a serious one.
26:59
So they throw in lots of liquidity.
27:01
And then the other thing they did, particularly around the time of COVID, was to put interest
27:05
rates down to near zero levels.
27:07
Well, that just encouraged everyone to term out their debt.
27:10
And people were basically terming debt out in 2020, 21, 22 at very low interest rates.
27:17
But they were terming it out five years later, let's say, in 26, 27, 28.
27:23
And that is now likely to come back onto the horizon.
27:27
Now, you'll see that in this chart, which is showing the change in the average debt
27:31
role.
27:32
And look at that bunching around the end of the decade.
27:35
There's a lot of debt to refinance.
27:37
That could be household debt, syndicated loan debt.
27:40
That's debt of high-yield bonds.
27:42
There's government debt.
27:43
Everything's sort of coming up into that concentrated period.
27:48
And the reason this is so unusual is that, you know, when I was at Salomon Brothers in
27:52
the 80s and early 90s, the Bible that everyone looked at and read was a book called The History
27:58
of Interest Rates by Sidney Homer.
28:01
And that book, which is sort of the Bible of interest rates, goes back, I think, 4,000
28:08
years.
28:09
Nowhere in that book is there any mention of zero interest rates.
28:14
So in 4,000 years, we haven't had it, but we did have it in COVID.
28:18
Even negative rates, in fact, as you recall.
28:20
And that's why it's so unusual.
28:22
And that's why we're kind of recovering from this mess, because basically that incentivized
28:26
everybody to take on more debt and turn out the existing stuff.
28:30
And this is the problem that we're creating.
28:32
So what you're getting is this debt roll.
28:34
The other thing that I going to say which kind of hooks into your point your very good point about AI is that a lot of the liquidity that we had in the system over the last five years or so has come through the big tech firms in the US who have generated vast cash flows They haven invested in them particularly They basically kept them in treasury
28:56
They've been out there in the money market sitting near fueling liquidity. But now the tech spend
29:01
is eye-wateringly large. I mean, from the latest figures I saw, the tech companies are spending a
29:08
billion dollars a day on new capex in AI or whatever. So you're talking about over a two-year
29:15
period, probably as much as $2 trillion, sorry, as a trillion dollars of new capital spend. And
29:21
that is clearly money that is coming out of financial markets. Money that's anywhere must be
29:29
somewhere. And the fact is, if it's in the real economy, it's not in financial markets.
29:36
And that's the reality. So you get to this slide that I've just put up here. And that's saying,
29:41
this is the problem that everyone's got to start thinking about. This is the debt liquidity cycle.
29:46
At the heart of the system is this collateral stability requirement, which is saying that the
29:53
US Treasury market is absolutely key here. We've got to have a stable Treasury market.
29:59
That's why you've got the Fed and the Treasury geared up, I think, to maintaining volatility,
30:04
a low volatility. And the way that you can understand that is to look at that left-hand wing,
30:12
which is how debt is converted into liquidity, because basically you need high-quality debt to
30:18
create liquidity. And what it's saying is that the repo collateral markets are absolutely central
30:24
here. And you've got to look at things like the move index or SOFA spreads. And here are just two
30:30
examples. This is looking at sofa spread. So this is saying, is there a shortage of good quality
30:37
collateral in the system or a lack of liquidity? And this is showing when you get spikes. Now,
30:43
there's been a lot of spikes or a lot of activity in the last 12 months. So you can see that if this
30:50
is looking at the pulse of a patient in a hospital, you can see that they're getting pretty excited
30:57
here. And they're moving up towards a coronary or whatever it may be. But this is the thing.
31:03
Federal Reserve is onto this, and they're trying to keep these rates down as best they can
31:07
by changing bank reserves. And that's why I think that it's going to be really, really tough
31:12
to rebuild the TGA in the next six months without there being a serious problem.
31:17
So I trust the Fed is up to this, is onto this. And so that's why I think there needs to be
31:22
some fundamental change in their operating procedures. And here's the move index just
31:26
to show what's been going on. And I've been arguing this point about move volatility coming
31:34
back into this range and there being a target. And I was accused, I think, in one of the financial
31:39
newspapers, maybe it was the FT a few days ago, sort of launching a conspiracy theory. I don't
31:45
think it's a conspiracy theory. It's just a fact. I mean, it makes absolutely every sense in the
31:50
world for the Treasury and the Fed to target volatility, because hedge funds are key buyers
31:54
and the collateral markets are critical.
31:56
So why not?
31:57
So, you know, that's the story.
32:00
And that's the risks that people face, I think.
32:03
But we're not over yet, you know.
32:06
The fat lady hasn't sung.
32:08
No, it's...
32:09
I'm sorry for interrupting,
32:11
but it's just very interesting
32:12
having you walk through that.
32:14
It's making some headlines
32:16
and thoughts I've had become much clearer.
32:20
You mentioned stable coins earlier.
32:21
Obviously, the expedience with which the Genius Act got passed here in the United States makes a lot of sense in retrospect, considering they're looking for buyers of the of the bills.
32:32
But then on top of that, as it relates to Bitcoin and stablecoin specifically, I think another change that's been made this year that many people still aren't paying enough attention to is the sort of the elimination of SAB 121, which had some very strict and reserve requirements for any bank that was going to hold Bitcoin or other altcoins.
32:58
and they changed that to SAV-122.
33:00
So now banks can take Bitcoin as collateral if they want.
33:03
And going back to your point of the system is very collateral dependent,
33:08
it seems like they're trying to open up as many gates as possible
33:11
to stuff new types of collateral into the system.
33:15
Yeah, I think that's right.
33:16
I mean, I think the thing is that stablecoin are a great mechanism
33:21
to buy treasuries, to buy bills in particular, to help fund the treasury.
33:25
But it basically creates a sort of, if you like, from the Treasury's point of view, a kind of virtual circle.
33:32
And the reason for that is if you think back to sort of monetary economics, what happens is if a credit provider basically buys a government debt, any government debt, they monetize the government debt.
33:46
So it's effectively printing money.
33:47
And the fact is that if you're issuing lots of bills or short-dated debt, that's really
33:54
attractive to credit providers.
33:56
And this is what the banks essentially hoover up.
34:00
So what you can see in the data right now is that looking at the growth of bank balance
34:06
sheets, it's being driven a lot by purchases of government debt.
34:11
This is monetization.
34:12
So what we're doing is we're embarking down the route of monetary inflation.
34:16
I mean, these are the fears that everyone's got. And that monetary inflation is ultimately going
34:21
to come through in terms of devaluing people's wealth or just increasing the cost of living.
34:27
And so what you need is dedicated monetary inflation hedges. And that means gold,
34:31
it means Bitcoin, et cetera. And I think the whole, I mean, Bitcoin, in my view, is definitely
34:37
the future. And I think that the US officially has to endorse that pretty quickly before somebody
34:44
else does. And I think that if the US wants to maintain control of the global financial system
34:49
of the dollar, it makes every sense to get on board with Bitcoin pretty quickly. Because what
34:56
would happen if China did, for example? I think it would be important to get that staking quickly.
35:05
Completely agree. And I'm just looking for a tweet that sort of validates exactly what you just said.
35:12
And Luke Roman has been paying attention to the sort of squabbling between the U.S. and China specifically.
35:18
And he tweeted out, I'm not sure if you caught this headline this week, but it seems like China wants to get a digital yuan stable coin out there.
35:27
And Luke just posited earlier this morning.
35:30
So what happens when China launches 0% yielding yuan stable coins backed by finite gold to compete with 0% yielding USD stable coins backed by infinity bills?
35:39
will the reaction of the USD stablecoin proponents mirror the seven-minute abs guy
35:44
from something about Mary? And I think he's alluding to, are they going to have to back it
35:48
with Bitcoin? Yeah, very sensible. I mean, he's had some great calls in the past, yeah.
35:53
Yeah. And I want to take a step back and just, you having been in the markets for decades and
36:03
looking at this, going back to the scene wave, the 65-month trends, what's driving that? Is it more
36:09
sociological human nature, whereas a mechanical based purely off the duration of debt that's
36:16
issued?
36:17
Is it mechanical?
36:18
Well, it's a great question.
36:19
I mean, I can't do the question justice with a decent answer.
36:24
But my answer is that if you look at the frequency of that cycle, it pretty much is in line with
36:32
the average maturity of debt in the world economy.
36:36
so you know the average the cycle fluctuates with a five to six year frequency and that's pretty much
36:43
the average maturity of debt out there about five to six years so that would kind of make sense so
36:47
it's a debt refinancing cycle yeah and that was just i had a hunch that was going to be your answer
36:54
and if that is the case like do we have to rethink is there the potential to rethink how we're
37:01
issuing debt to rethink duration does it make sense or is this just the way what it would
37:06
basically say that if we're changing the tenor, the average tenor of debt out there, we're going
37:11
to change the average tenor of the cycle. So you're going to get shorter cycles if we're doing
37:16
more debt issuance. And you can see the logic in that, how that would work, is if the Treasury is
37:22
always issuing three-month, six-month bills, they're always going to have a big problem every
37:28
three to six months when you effectively get a roll or if that debt is bunched and you get a roll.
37:33
yeah and then now my mind's wandering too like does this like the reintroduction of patient
37:41
capital like long term like did like you mentioned it earlier too like this transition to hard assets
37:47
is this how it happens you just have a sort of not even asymptotic but you just have a
37:52
accelerating sort of market turnover because you're getting shorter and shorter on the curve
37:59
as you as refinance the debt, that at some point the system needs to transition to something else.
38:06
Yeah, I think that makes sense. I also think that an interesting thought experiment
38:11
is just to say, well, what would happen in the world if there are only two assets that you could
38:17
invest in? You could only invest in short-dated government debt, or you could invest in Bitcoin.
38:22
what would happen? And you could see under that situation that you would get Bitcoin moving with
38:32
the financial sector 100%. And whenever there was expansions of liquidity, investors would
38:39
basically take on more risk and put more money into Bitcoin. And so you could see Bitcoin being
38:44
highly, highly pro-cyclical with the liquidity cycle. Now, the reason I cite that is that a lot
38:51
people look at macroeconomic fundamentals, in other words, what's happening in the real economy,
38:56
to judge what's happening in the equity markets. Right now, what you've got is a situation which
39:02
is a great paradox. It doesn't seem to be any cycle in the real economy. The economic data is
39:07
kind of blowing two or three different ways. No one really knows, are we in a boom or a bust or
39:12
whatever it may be. But if you look at the markets, they're performing just as if it's a very,
39:18
very normal cycle. And I'll demonstrate that because I think it's an interesting point
39:23
to ponder. And let me just try and show you what I mean by that. And this means sort of coming back
39:31
to, in fact, this diagram. So if you think about the cycle here, so let's put that into a framework
39:40
and think about the asset allocation cycle, which I'm about to show here. So this is showing that
39:47
schematic cycle. So what you have on the left-hand side is what asset classes tend to do well as the
39:55
liquidity cycle is evolving. And on the right-hand side, we basically describe the phases of the
40:01
liquidity cycle as we understand them. Now, what this broadly says is that in the upswing of the
40:07
cycle, you want equities. This is traditional asset classes. Bitcoin is a risk on asset. So it
40:14
generally does well when you're in the upswing. And in theory, it should do not so well if you're
40:20
in the downswing. We have a lot of evidence of a downswing of late, but we'll see. Commodities
40:26
around the top, then cash on the way down, bonds at the trough. And this is how that translates
40:33
into different asset classes and different industry groups. Now, bear in mind what I just
40:39
said about the fact that there's no business cycle, or it's really difficult to perceive a
40:44
business cycle right now, because the data is blowing in so many different directions. No one
40:48
really knows. Is it recession? Is it recovery? Who knows? But if you look at the cycle of market,
40:55
the market cycle, it's absolutely normal. So if you're in the rebound stage of the liquidity cycle,
41:01
so think of assets on the left and industry group sectors of the S&P, let's say, on the right-hand
41:07
side. If you're in the rebound area, which is the early phase of the cycle, so that was basically
41:12
2023 or thereabouts, maybe to mid-24, then you were looking at equities doing well, credits doing
41:20
well, commodities not so well, bond duration, forget it, bad. As you move towards calm, you want
41:27
equities, you want to start to migrate your credits more into commodities and stay away from bond
41:33
duration. And then you can see how that cycle migrates from left to right. And then if you
41:39
look at industry groups, then you say, well, in rebound, what I want is just I want cyclicals,
41:44
but I really want tech. That's the strong outperformer. Then you get to calm. Tech still
41:49
does quite well. But you start to get financials coming through and energy where you look at the
41:55
yield curve steepening, as you'd expect now. Commodity stocks are beginning to get a bid.
42:00
financials around the world. Look at European banks have been on fire. JPM's up quite a lot
42:06
in the US already. It's still a bit lately, but it's had a good performer over the last 12 months.
42:12
Regional banks are doing pretty well again. So you're looking at financials, energy commodities
42:18
doing well. So this seems to be a really, really normal cycle when it comes to market movements
42:25
and liquidity. But you can't pick that up from the real economy right now.
42:30
No. Now, there seems to be a very stark disconnection from financial markets and the real economy, at least here in the United States.
42:38
And you have the Silicon Valley crowd really beating the drum about this A.I. wave being a boon to productivity.
42:46
And that's why we're seeing profit margins increase without any new hiring at a bunch of the Mag seven companies, particularly Meta, Google, Microsoft.
42:59
And I think that's what's making me cautiously, I mean, just cautious.
43:06
Generally I don even want to say cautiously optimistic is that real or is it a bunch of people with very high incentive to beat that drum trying to will it into existence And I think that something even within the Trump administration
43:22
I think David Sachs and others that are more tech forward within the
43:26
administration are saying, Hey,
43:28
we have this window of opportunity to really take advantage of this,
43:31
this step change, improvement and productivity across the economy.
43:37
And I think that's a lot of people are,
43:40
We're just in this extremely uncertain period of time due to where we are from a debt situation, where the liquidity is.
43:49
And then on top of that, you have this compounding external factor of this new technology.
43:55
Yeah.
43:56
Yeah, I guess, Marty, what I'm saying in a way is to look, if the financial markets have got no strong connection with the real economy,
44:04
What you're getting is potentially a threat because you're getting, as I said, a trillion dollars coming out of the markets over the next, well, this year and next year because of tech investment spending.
44:17
And that's a lot of cash.
44:18
Yeah.
44:19
Yeah, there's a lot to chew on here.
44:26
Because it's having only been observing financial markets very closely since the great financial crisis.
44:34
Like I've seen a couple of these cycles.
44:37
And to my point earlier, it does seem like things are accelerating and the cycles are shortening.
44:43
I mean, 08 to the European credit crisis in the early 2010s, then obviously COVID 2020, banking crisis of 23.
44:56
And now here we are today.
44:57
It seems like we're in a precarious situation yet again.
45:04
I don't really have a point there, but I'm just like trying to think through this of where it ends.
45:10
And so in terms of Bitcoin, that's something I wrote in the newsletter this morning, too.
45:15
Like if more and more people are observing these cycles compressing and getting more extreme in terms of the response to any downturn in terms as it relates to money printing and debt issuance.
45:27
I wonder Bitcoin being 16 years old, like does the muscle memory get to a point where if there is another downturn, people wake up and say, all right, it's obvious that something's wrong in the traditional financial system with these boom and bust cycles.
45:48
This alternative here in Bitcoin is completely separate from that in many regards.
45:54
and historically it's been a risk-on asset.
45:59
Do you see it potentially transitioning to risk-off?
46:03
I think it's a very interesting point.
46:06
I think the thing is that, look, the plain fact is that you've got a trend
46:13
and you've got a cycle to contend with.
46:15
And I think there is a liquidity cycle which essentially is driving the ups
46:21
and downs short term in Bitcoin makes a lot of sense because it's a very liquidity sensitive asset
46:26
because it responds to monetary inflation. And that's what we've got through the cycle.
46:30
But we've got a trend, an exponential trend, which is basically debt driven, which means that
46:36
over the long term, just because of interest rate compounding, not least the fact that you've got a
46:42
positive primary deficit as well, adding to that debt burden. But the interest payments and the
46:48
primary deficit mean that debt is growing exponentially, liquidity has to keep pace with
46:54
that. So what people are not really understanding, as far as I can see, is that what has really
47:00
changed post-COVID, in particular, is that the debt burden is just growing at a much, much faster
47:06
pace. And it's really difficult, particularly with aging demographics and the need for defense
47:11
spending, et cetera, to actually to rein that in in any way, shape or form. So what you've got to
47:18
do is you've effectively got to monetize that or at least keep place with liquidity. And therefore,
47:22
you've got to have monetary inflation hedges in your portfolio. And that's why Bitcoin makes so
47:27
much sense in the long term. And what I would say on top of that is it's a strategic asset.
47:33
So that kind of lends its way to your point about being, is it going to be accepted more as a safe
47:38
investment. Yes, I think it will be for sure. Because outside of the domain of central banks
47:44
and governments, absolutely. But you've got to think about the growth of Bitcoin in terms of
47:51
both the intensive margin and the extensive margin. And in terms of the intensive margin,
47:57
let's call that the liquidity cycle. And let's call the extensive margin the fact that you've
48:02
got more and more and more people who are going to embrace this asset over time. And that's what
48:08
it's going to give it a lot of its trend growth. So I think if you look at it through those two
48:12
lenses, you can put it into context more easily. Yeah. That's a fascinating time to be alive.
48:21
I've said this many times in the last few months, it's equally unnerving and exhilarating
48:25
because of everything going on. Untrodden ground. Yeah, it really is.
48:31
in the last
48:33
the last topic you mentioned
48:36
in the beginning I meant to follow up
48:38
I forgot but I think it is
48:39
something that could be worthwhile
48:41
you alluded to China's
48:44
sort of influence on
48:45
the liquidity cycle
48:46
not necessarily throwing a wrench
48:49
but obviously having an impact
48:51
in a certain way what is China doing
48:53
that's
48:54
let me just shift on to what's going on
48:57
in China
48:58
I'll allude to that
49:00
Okay, let me just swing out of here.
49:04
This is through the bond markets to where we are, dollar, China.
49:11
So in terms of China, this is looking at the Chinese bond market.
49:16
Every bond market tells a story.
49:18
And what you've got here in the Chinese bond market, yellow line or orange line is looking
49:22
at 10-year yields, and the black line is the term premium or risk premium on Chinese bonds.
49:28
The fact that the black line is going down and it's pulling down the orange light is saying that you've got a big rush for safety in China.
49:36
Investors are basically going for safe assets.
49:38
Now, that black line, which had been going down, is stabilizing.
49:43
And that stabilization is a good thing because it's basically telling us that we've probably reached a floor in yields.
49:49
And what you're seeing now is probably a switch of assets among Chinese investors into more risk assets.
49:57
So the Shanghai index has begun to pick up quite noticeably. Now, the reason that that is going on
50:04
is that, if I can shift to my next slide, this is what China needs to do. So this is the debt
50:13
liquidity ratio in China. And what I said is that if you look at different countries, they need
50:20
stability in their debt liquidity ratio. If you've got a very high debt liquidity ratio,
50:25
You've got refinancing problems in your debt markets, and you face debt deflation effectively.
50:31
That's what China's got.
50:32
That's what the bond market has been telling us.
50:34
So they've got to get their debt liquidity ratio down.
50:37
You do that in one of two ways.
50:38
You default your debt.
50:40
No financial system can afford to default debt because debt is collateral.
50:44
So you can't do that.
50:46
You've got to increase liquidity.
50:48
And so they've got to start printing money.
50:50
And that's broadly what they've been doing.
50:52
Probably this chart is a better one to show it.
50:54
This is looking at the amount of money going through Chinese money markets.
50:59
And you can see the increases and decreases in that.
51:03
Basically, what they've done is they've had two or three goes of actually injecting large
51:07
amounts of liquidity into their markets.
51:10
I've shown a year on year change because there is huge seasonality in Chinese money markets
51:16
to a very large extent because China is still very much an agricultural economy or has large
51:21
agricultural elements.
51:23
And so there's a lot of seasonality in terms of the money flows in the markets.
51:27
But you've still got that issue.
51:29
So I've looked at it cleanly here in year-on-year changes.
51:33
Why was 2024 so depressed?
51:36
Because what was happening was the Chinese were trying to shadow a strong dollar, and
51:40
they couldn't do it.
51:41
And what they've done really since the beginning of 2025 is to throw the towel in, helped by
51:47
the fact that the dollar took a little bit of a respite.
51:49
So they put a lot of liquidity into markets.
51:52
That is important.
51:54
We need to see them keeping that up.
51:57
The last four weeks have been a little bit mixed, so it's difficult to know the direction.
52:03
But I was very encouraged at the beginning of the year.
52:06
I'm still moderately optimistic.
52:08
But the Chinese market has been a strong outperformer this year, and it may end up being one of
52:13
the strongest markets for the year as a whole.
52:17
This is just looking at the evidence of what they're doing.
52:19
But I want to show this chart and the next one as a conclusion.
52:25
This orange line is really what you've got to try and monitor.
52:29
This is the yuan gold price.
52:31
The black line is the yuan US dollar cross rate.
52:35
Now, everyone in the market seems to be focused on the black line.
52:39
And they like the stability that you see.
52:42
They're around 7.1, 7.2, 7.3 renminbi per US dollar.
52:48
But that's fine, OK?
52:51
But behind the scenes, you've missed a lot of what's been happening in the gold market.
52:56
And the Chinese gold price has absolutely skyrocketed.
53:01
Now, gold everywhere, I know, has gone up.
53:02
But the key point here is that I think this is a deliberate move because it reflects the
53:08
monetization that's going on in the Chinese economy.
53:11
And China is the world's biggest producer of gold.
53:14
They obviously are accumulating gold internationally.
53:17
They buy it. Anyone that wants to, any government that's selling, the Chinese are normally buying it.
53:24
So they're accumulating gold. As a Chinese citizen, you can hold as much gold as you want,
53:30
but you can't export it. So it's a natural hedge for people in terms of that economy.
53:36
And the Shanghai gold market is really the leader now worldwide. It's the marginal pricer.
53:41
So if you want to know what's going to happen to the gold price, in my view,
53:44
What you need to do is to understand the dynamics in the Chinese monetary system,
53:49
the fact they're monetizing and devaluing their real assets against, sorry, devaluing
53:55
paper money against real assets.
53:57
And a real asset here is gold.
53:59
So they want to get paper money debts down.
54:02
They print lots of money to do that.
54:05
And what you see that evidenced through is a rising yuan gold price.
54:09
Now, our view last year was that that had to get to a minimum of 24,000 yuan to make
54:16
any dent or scratch in the debt problems that China has.
54:20
It's got there.
54:21
They've held it there lately.
54:23
But I think it's going to have another jump up.
54:25
So I'm very optimistic of gold.
54:26
And if I'm optimistic of gold, I've got to be optimistic of Bitcoin.
54:29
So that's the backdrop.
54:31
But whereas the Federal Reserve has its major leverage on the financial systems worldwide
54:38
and on financial assets. China's People's Bank has its major leverage really on the real economy
54:44
because the Chinese economy is so controlled by the PBOC. And secondly, it's got a big economic
54:50
footprint worldwide and regionally. And this chart, the next one, shows movements in Chinese
54:57
liquidity against world commodity prices. The orange line is Chinese liquidity. We've
55:04
extrapolated that is shown as an index of liquidity impulses. So that's showing data from 2004 onwards.
55:12
The orange line is just showing there's potentially another big inflow coming. I mean, that's partly
55:18
guesswork or projection, but that's what I think is going on. And the black line, solid, is all
55:24
commodity prices of the CRB index. And the dotted black line is X energy. So just to show there's no
55:31
bias with oil prices, but that shows the picture. So what it says is, if you're going to get a lot
55:37
of Chinese liquidity expansion, you're going to get commodity markets up, but you're going to get
55:42
the gold price up. But that's quite consistent because gold typically moves about six to nine
55:47
months before commodity markets do. And that's what we're expecting.
55:53
Yeah. I imagine terrorists are really accelerating this since they're on gas on this fire as well.
55:59
Yeah, because the Chinese economy is suffering really badly from the tariff heights.
56:06
Yeah.
56:07
And then the way I understand it, the capital flows historically up until recently,
56:15
with Trippin's dilemma hollowed out, our manufacturing base export it to the rest of the world,
56:21
buy their goods, and then they take the cash that we buy those goods with
56:25
and pump it back into our financial markets.
56:27
And there's some disruption in that flow, right?
56:29
out too um yeah again equally unnerving and exhilarating uh if you like to nerd out about
56:38
this stuff and michael i can't thank you enough for spending an hour on your friday uh early
56:44
evening to uh to walk through this with me this is a great question marty thank you the pleasure
56:49
is all mine sir this is um incredibly illuminating and high signal content so thank you for putting
56:55
it together um anybody's listening to this who's not subscribed uh to cross border to michael's
57:02
sub stack go uh go subscribe it's incredible and it's called capital wars by the way yeah capital
57:09
wars you guys did a collaboration with the bitcoin layer um team earlier this week nick batia
57:16
crew that was really good i really liked the bitcoin color in that one
57:20
yeah
57:20
yeah that was a good Q&A
57:22
awesome
57:24
well
57:25
I'll let you
57:25
enjoy your Friday night
57:27
hopefully
57:27
we can do this again
57:29
maybe we'll
57:29
maybe we'll meet
57:30
at the peak of the cycle
57:31
at some point
57:32
in the next six
57:32
to nine months
57:33
yeah
57:35
I just hope it's a way off
57:36
but anyway
57:36
look forward to the next
57:38
engagement party
57:38
thank you
57:39
alright
57:39
have a good one
57:40
peace and love freaks
57:41
okay