Raoul Pal & Michael Howell: Why Liquidity Matters More Than Anything Else

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1:24And now to the top analysis of today's markets. Mike Howell is really the pioneer of liquidity and understanding liquidity. I've gone down the liquidity rabbit hole super deep myself. And I really wanted to talk to Mike about some of my ideas and hear his ideas. I think it's incredibly important. I think most people don't fully understand it and its implications. So let's sit down with Mike, dig in and find out how liquidity is going to change everything. Macro investing is a journey. Join me, Raoul Pal, as I go on a journey of discovery through the macro landscape. This is how I build my macro framework, by talking to the smartest people in the world.

2:14Mike, fantastic to get you back on Real Vision, but I think it's the first time you and I have actually sat down and chatted. You're probably right, Raoul, yeah. I've been on Real Vision a few times, but I think this is the first occasion. So first in many ways. Really looking forward to this. I'd love for you just before, just to give people a bit of your journey, where you came from and what you're doing now, just to frame it for people. OK, well, if we start from now and work backwards, Cross Border Capital was set up as an advisory firm in the late 1990s. Prior to that, I'd been head of research at a company called Bearings You probably remember it hit the headlines.

2:55And then prior to that, another firm that hit the headlines, Salomon Brothers. So I pretty much started my career at Salomon where I was a research director. And in fact, before finance or before Salomon, I was in academia. And then I made this transition, but I've been in finance for more years than I can remember since the mid 80s, really. Yeah, I've been there since the very early 90s. So I was James Capel, if you remember, when you were at Barings, I was probably at Capel's and then NatWest and then Goldman. Familiar names. Your work on liquidity is, I think, truly exceptional. And you're one of the real thought leaders in this space.

3:36And I think a lot of people still don't fully understand what how liquidity is driving things. So if you can talk through your top level thesis of how this all works? And we'll dig into a lot because there's a lot of questions I want to ask you because I've been doing a lot of work on this myself as well. Okay. I think the starting point to say is that liquidity or understanding flow of funds was the primary research tool at Salomon Brothers. I mean, that was basically how we understood the fixed income markets and the forex markets. It was about liquidity flow. And if you remember the name Henry Kaufman, Henry Kaufman was head of research at Salomon.

4:16He was a pioneer of flow of funds analysis, used to pour through the Z1 accounts, as they were called, that the Federal Reserve puts out, and basically would come up with assessments of US interest rate outlook. He used to call that prospects for financial markets, which was an annual publication. I took the same template because you could see that liquidity was important. I'll come in a second to define what we mean by liquidity and basically put it into a global context. So to say, well, it wasn't just the Federal Reserve and the US that was now important. This was, you know, we're talking about the late 1980s, early 90s.

4:53The world was becoming a bigger place. Other countries were becoming prominent. Japan was clearly a big example. Europe was sort of muscling into financial markets. There was deregulation, capital flows were weaning around the world. And so you needed to have something more than just a US vision. You had to look and see what other countries were doing. So that was really my template. In terms of what liquidity is, and what we're measuring, and how it's working, the first thing to say is it's not about interest rates. It's not a substitute for saying, you know, let's look at what the Fed is doing with policy interest rates.

5:32Liquidity is a whole different dimension. And what we define it as, as the flow of cash and credit through global financial markets. Okay. Now, it's not conventional money supply. Money supply, as defined, is the retail deposit liabilities of high street banks. Okay. So if you believe the financial system, that's all the financial system is, then I'll come quietly and say, well, okay, all we need to do is look at money supply. But banks are funded now with other instruments besides retail deposits. They can get secured financing. They can issue debt, whatever it may be. They can go to repo markets.

6:16There's a whole host of other financing vehicles. And banks are not the only part of the equation. What you've got are wholesale banks. You've got the repo system, shadow banking, cross-border flows of money. Essentially, you've got an international dimension, and you've got a financial system that are becoming more complex and more sophisticated. And so there are other sources of liquidity. So in many ways, a lot of the definitions that we use in terms of liquidity begin where the traditional monetary aggregates end. And that's probably a decent way of looking at it. Ours is a fundamentally wholesale measure of liquidity.

6:55It's very focused on the financial sector. It is not money supply. I'm not saying money supply is unimportant, but money supply is much more relevant for the real economy and spending in the real economy around the world. I've got a thesis, and I wanted to run it by you, that everything in the world changed in 2008 or 2009. And obviously, we went to zero interest rates pretty much globally. and we started the use of the central bank balance sheets as a form of liquidity within markets. I noted, and it took me a while to realize this, but I noted that essentially, we then became incredibly cyclical, and you've pointed this out, and it was a light bulb moment when I saw that and I started digging into it, is that it seems that everybody in the world reset all interest rates in 2009.

7:48And we seem to be at a three and a half year refi cycle. Can you talk us through your thinking around this? Because this is, I think, a lot of people don't understand this yet. And I think it's really crucial. Yeah, I think you make an extremely good point. And let me try and start off with how we think about things. The first thing to say is if you pick up a textbook, whether it's a finance or an economics textbook, what they say is interest rates It's the paramount factor to look at, OK? Now, in a world where you've got a lot of capital spending going on and you've got to compare a cost of capital with a return on capital, I'll come quietly and say interest rates matter.

8:27But that's not the world we're in anymore. We're in a world where there's huge amounts of debt refinancing going on. So$350 trillion of debt worldwide with an average maturity of around five years means you've got to roll over something like$70 trillion of debt every year. Now, it doesn't matter so much what the interest rate is. I mean, clearly, it's important, but that's not the critical point. Think of it in terms of a home mortgage. If you need to roll forward your home mortgage, refinance your home mortgage, it's not the interest rate that really matters to you that much. It's whether you get the roll.

9:02Because if you don't get the roll, you're homeless. And the same with the corporate. If you don't get the role on your debt, you default. So it's the role that's important. If you've got 70 trillion of debt to refinance every year, you need balance sheet capacity to do that. And balance sheet capacity is a measure of liquidity. And so liquidity is the paramount factor in markets now. In a world of capital spending, sure, interest rates are relevant. But in a world of huge debt refinancing, what you've got to do is essentially get the capacity. And that is all about liquidity. If you do the math and you look at it in terms of, let's quantify this, for every$1 of new financing in terms of capital spending, you've got$7 that are transacting in financial markets today for debt refinancing.

9:47So a seven to one ratio. That's why liquidity is so important. If you don't get that role, if you can't refinance, you have a refinancing crisis. Most of the crises that you look at historically, whether it's be 2020, 2019, the current situation, 2008, 1997, they're all refinancing crises. So one of the things I've also looked at is I've looked at a broader level and thought, OK, GDP is the primary driver. It's the revenue, everything that generates within the economy. So if I look at GDP growth, we can use the formula of productivity times, you know, it's productivity, demographics, and probably debt growth are the three components of GDP.

10:33And demographics are bad. So it slows GDP. Productivity has been terrible because of the demographics, and that's been slowing GDP. So we've had debt growth. And that seemed to have got to a point where we got to that 100 % of GDP in debt by the government sector. Now, what's really interesting, this is what I want to really dig in with you about, is I started looking at this and realizing, well, if trend rate of GDP is like 1.75%, and interest rates, long-term interest rates are somewhere around the same, there's still 100 % of GDP that goes in paying the government debt. And then the private sector is another 120 % of GDP, excluding the finance sector.

11:19So there's not enough GDP to pay the interest. So what I found out is that when I backed out the quantitative easing, I found out that it exactly matched the interest payments that were for the prior three and a half years. And so it seems that the Fed balance sheet is being used to monetize those interest payments so it doesn't crowd out the private sector, which is creating this massive cyclicality that we're seeing from the liquidity cycle. I don't know if you looked into some of this. I haven't exactly, but it's what you're saying is extremely plausible. I think that's right. And what you're what you're really saying is that a large part of the debt burden that we're seeing every facing every year is actually interest payments.

12:04And if the Federal Reserve is having to come in and actually buy that debt, then you can see a very strong correlation between the interest bill and effectively QE. And I think that's if that's true now, I can assure you it's going to be absolutely true in the future because the way the government finances are working. I mean, it looks absolutely terrible over the next 10, 20 years. Now, within that context, the US is bad, but the US is the cleanest shirt in the laundry here. other countries are in a disastrous situation. And I think I picked up on, maybe it was listening to a Real Vision interview you were doing maybe a couple of weeks ago or something, where you're making the point about tech and AI, and that is the future.

12:51And I go along with you, it is. But then you come back and you think, well, hang on, what are the implications of that for tax take. That's where it gets really scary, because what you've got is a situation where demographics are aging. Okay, we know that. Mandatory spending is skyrocketing. Just look at the Congressional Budget Office projections here. They're looking really bad in the next 10 years. They really start to zoom up. But then look at the tax take. The tax take is based on unconventional assumptions. And the fiscal deficit gets big. But then if your thesis is correct, which I think it absolutely is, and you get this breakthrough in AI, you get job losses, how are you going to tax people in that environment?

13:40The tax base at the moment is squeezed dry. You can't raise tax rates anymore. The more you raise tax, people are going to go offshore, they're going to find other ways of working. And so the government is in a real they haven't thought through this AI dimension at all. And so the only thing you've got is you've got to have the central banks come in and do QE. That's the only thing that's done. Hey, everyone. We're going to take a quick pause and hear our word from our partners. We'll be right back.

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15:09Yeah, because look, I think the technology drives the productivity part. Not necessarily immediately, but over the next few years, I think we'll see productivity start to rise. particularly as some of the baby boomers leave the demographics. But they're going to have to tax the robots or they have to figure a new way of taxation. Because also, as we know, in this technology world, if we're not careful, it's going to accrue to some very, very gigantic firms. And they're going to have to think of some way of the tax take because the human population can't pay the taxes. It's just that they don't add up.

15:46People are going to be disenfranchised from technology. They don't want to be earning in the same way as they had before. The tax structure just won't work. And so governments are going to have to rethink this whole thing. So it means you've got to do QE, which basically means that reserve currency status in the world is going to be of paramount importance. And that's why the dollar is actually in a much, much better position than many people think. Exactly right. So this is why liquidity is so important, because the system does not function without it anymore. Before it was one of the key drivers, it's now the key driver.

16:23When I put together our kind of liquidity metric, and if we use just the, even just the G5 central bank balance sheets as a simple proxy for liquidity, not as sophisticated as some of yours, was the S &P correlation is 97.5%. Yeah. Yeah. Because liquidity is everything. And one of the ideas that I've got that people still dismiss is that this is actually debasement of currency. So you're actively, what you're doing is lowering the value of the denominator. The dollar is still king in all of this. People get confused because of currency versus the value of the purchasing power of fiat currency.

17:00But it seems that it values the denominator every time they use the balance sheets. Exactly right. And I think the thing is, is you've got to then look at what I call monetary hedges to effectively to avoid the problem of governments debasing money. Now, gold is the traditional monetary hedge. I think one of the ways that people get muddled by this is they associate gold as being an inflation hedge, a high street inflation hedge. It's not. It's never been that. It's always been a monetary inflation hedge. It so happens that monetary inflation can feed into high street inflation. But that's not the starting point is monetary inflation.

17:38And the other is crypto. Now, if you look, if you combine, and I've probably shown you charts before, and I think in a pack I've got that evidence. But if you look at what I call monetary hedges, look at the market cap of gold plus the market cap of all crypto, that moves with liquidity almost one for one. OK, so if you're going to get this process of QE, what you'll see are monetary hedges zooming in the next few years. And that means gold and it means crypto. Now, the sort of the spooky corollary to that is that last time this happened, when you saw serious threat to paper money systems in the 1930s, gold was banned by the US in 1933 or 1934, if I remember my history.

18:25And that's one of the dangers you've got in the current space. Are they going to try and find ways of actually stopping investors, putting money into crypto or these monetary hedges? I would think it's probably too difficult now to do. I know what you think. It's large and owned by a lot of people now. And it keeps rising. One of the things I've done is also I just divided various assets by just the Fed balance sheet or the G5, either way. And what you found is the S &P went nowhere since 2008. Gold actually didn't go anywhere. So it offset the debasement, but didn't actually gain anything. Real estate, same.

19:05The only ones that did were crypto and technology, because they were secular trends. And those two massively outperformed the Fed balance sheet. And once I kind of saw this, I realized that, you know, if this is the world we're in, then there are only really two assets. Yes, you can own gold, and it will work. But if you actually want to make money in addition to the debasement, you've only got a couple of assets you can really own. Right. Makes sense. Over a full time. Yeah, I think it makes sense. I mean, we're in a world where debasement has to be the order of the day because, you know, governments, I mean, you can see in many ways how governments are acting, even in the last few months.

19:41And what is of absolute importance is the integrity of their sovereign debt markets that will do anything to preserve those sovereign debt markets. And you can see that in the example of not just Japan, but more explicitly, look at what happened in the UK gilt market, the British gilt market in September of last year. Gilt sold off. That was a huge shock to the system. The Bank of England changed overnight from a QT policy, which they announced only days before to full-fledged QE again. And if you look at what the Federal Reserve has been doing over the last few weeks, and arguably, I would say actually since the British guilt crisis, but more in terms of stealth easing, they've been actually trying to underpin the Treasury market as well.

20:24And in fact, the more general financial system. They have come back with liquidity, and that's their reaction every time. And the point is, and to come back to your your illustration of the post-2008 world, I think it's an extremely good one. And we've got to think a lot more about that. Because basically, before 2008, credit markets relied to a large extent on trust. Post-2008, they demand collateral. You've got to have collateral. Collateral is what the financial system is all about. Now, if you want to get scared by this, take a look at the fixed income markets and something which is a wantish concept, but you'll remember from Goldman days or whatever, the term premier.

21:06OK, look at the term premier on the US Treasury market. It's published every day by the New York Fed. OK, that number is not just negative. But if you take out the inflation trend in that data, it's the most negative it's ever been. Now, textbooks will tell you that term premier should be positive, not negative. But they're hugely negative. They're the lowest they've been since records began in 1961, right? Now, what is that telling you? It's telling you there is an excess demand for collateral in the system, OK? And that is a fundamental problem. And that's why the financial system is potentially fragile.

21:44And that's another way of saying why the central banks have got to keep coming back and papering over the cracks with more liquidity. Yeah, and I think Basel III was another big part of that. But the forcing of the massive hoarding of collateral means there's an endless collateral shortage, which endlessly makes the dollar go up because it's a game of musical chairs because the whole world is a dollar funding mechanism. And as you say, they have to keep papering over the cracks because when something goes wrong, there's not enough collateral in the system. And it happens time and time and time again.

22:15Yeah. And you can actually, if you look at the fixed income markets globally, there are principally two markets worldwide, the Bunda market and the US Treasury market, where you see this phenomena of very negative term premium. And those are the two markets where you've got, you could call pristine collateral. Hey, everyone. We're going to take another quick break and hear a word from our partners.

22:40Yeah, the other thing, by the way, I looked at, as I went through and checked my numbers about this interest payments in QE, and it worked for Japan, it works for the UK, and it works for Europe, they're all the same. And it kind of felt like that maybe the central banks made an agreement that this is what they would do. Maybe the BOJ were the people who figured this out before everybody else. So I looked at all of the balance sheets, and they're basically interest payments, plus anything they have to directly inject into the banking system in terms of bailouts, which is the extra on top, because that's not the government funding side of the equation.

23:13Do you think that they might all know what they're doing? Because everyone always assumes central banks are morons and that they don't know anything. But when you kind of look at it and you think, huh, maybe you are just all monetizing the interest payments because you all hit 100 % of GDP and debt at government level. What do you think? I think it makes sense. I mean, I mean, they're certainly not idiots, that's for sure. You could argue that they may be a step behind the markets always. I mean, that was something we always felt at Salomon Brothers, that the Fed was in a learning process. And certainly the Japanese authorities were in a big learning process.

23:46So we're always a couple of years ahead of what they were thinking. But ultimately, they catch up and they put a lot of resources there. I think if you look at the alacrity with which central banks have moved in the last few weeks, it shows that they're actually concerned about the financial system. I would suspect in these upcoming IMF meetings, which are slated to go on in the next few days, you're going to see a coming together of policymakers saying they are going to avoid a banking crisis at all costs. The reason being is that it's absolutely in no one's interest to have a banking crisis now because you're presenting a gift to China.

24:23If China sees a banking crisis in the West, they'll say, look, told you so, don't rely on these guys. You've got to come with us and try and help the yuan be a new currency alternative. So don't give China or anything like that. So there'll be a coming together. And I think what that means is that central banks are going to offer more and more liquidity support. So your whole thesis and the idea that they're onto this, I think, makes huge sense. In fact, there is on Twitter, which I know you played and I played as well. If you look at Twitter, there is a comment by a former central bank official, and she said that what's going on right now is she terms it a daisy chain of support among central banks supporting the Treasury markets.

25:12Now, I'm not sure about the size of that. There may be some debate about that. In principle, I think it makes huge sense. Yeah, because they just can't let this whole thing fail. So I just want to complete the big picture, and then we'll dig into where we are now. So a lot of people hear what you're saying, and they immediately say, well, inflation. Now, where do you stand on structural inflation? Are you disinflationary natured, or do you think that we create a high level of inflation with all of this? OK, I think the first thing is that I'm fundamentally a deflationist, because I think that what the world is going through is a Japanification.

25:52I think Japan has shown the world what happens. And I think demographics are a huge, huge factor here. So I believe that that's where the trend is. On the other hand, if you look at what's happening in terms of central bank liquidity injections, in other words, it's monetization, you've got to say that there is a case, as we've seen in the last two years, of that liquidity spilling over from time to time into the price level. So my view is that the trend in inflation is probably downwards or it's low, but we've got a lot of volatility in that inflation rate. So that's the problem. Now, if you look at maybe the nearer term outlook, I'm certainly wedded to the idea that inflation comes down quite fast over the next few months.