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

The Importance of Liquidity in Financial Markets

In this section, Mike Howell discusses the importance of liquidity in financial markets and how it is a measure of balance sheet capacity.

Mike Howell's Background

• Mike Howell is the founder of Cross-Border Capital, an advisory firm.

• He has worked at Salomon Brothers and Bearings, where he was head researcher.

• He has been in finance since the mid-1980s.

Understanding Liquidity

• Liquidity is not about interest rates but rather the flow of cash and credit through global financial markets.

• Henry Kaufman was a pioneer of flow-of-funds analysis at Salomon Brothers.

• Liquidity is not conventional money supply but includes other financing vehicles besides retail deposits.

Importance of Measuring Liquidity

• Measuring liquidity helps to understand how cash and credit are flowing through global financial markets.

• Banks are not the only part of the equation; there are also wholesale banks and repo markets.

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The Future of Debt Burden and Interest Payments

Raoul Pal discusses the correlation between interest payments and quantitative easing (QE). He explains that a large part of the debt burden is actually interest payments, and if the Federal Reserve has to buy that debt, there is a strong correlation between the interest bill and QE.

Interest Payments and QE

• The debt burden we face every year is largely due to interest payments.

• There is a strong correlation between interest payments and quantitative easing (QE).

• If the Federal Reserve has to buy that debt, it shows how bad government finances are working.

Implications of AI on Taxation

Raoul Pal talks about how technology drives productivity but also leads to job losses. He highlights that demographics are aging, mandatory spending is skyrocketing, while tax take remains based on conventional assumptions. This section explores how governments will have to rethink taxation in light of these changes.

Taxation in an AI Environment

• Technology drives productivity but also leads to job losses.

• Demographics are aging, mandatory spending is skyrocketing while tax take remains based on conventional assumptions.

• Governments will have to rethink taxation as people will be disenfranchised from technology; they don't want to earn in the same way as before because the tax structure won't work.

• Central banks will have to do QE because governments haven't thought through this AI dimension at all.

Liquidity Cycle and Monetary Hedges

In this section, Raoul Pal discusses the importance of liquidity in the current financial system. He explains that liquidity is everything and that it's now the key driver of the system. He also talks about monetary hedges, such as gold, which can be used to avoid the problem of governments debasing money.

Liquidity Cycle

• Liquidity is everything and is now the key driver of the financial system.

• The correlation between liquidity and central bank balance sheets is 97.5%.

Monetary Hedges

• Gold is a traditional monetary hedge that can be used to avoid the problem of governments debasing money.

• Governments will have to think of new ways to tax people because demographics are aging, mandatory spending is skyrocketing while tax take remains based on conventional assumptions.

Monetary Hedges and the Fragility of the Financial System

In this section, the speaker discusses monetary hedges and how they are affected by quantitative easing. He also talks about the potential dangers of investing in these hedges, particularly in light of government actions to preserve sovereign debt markets.

The Role of Monetary Hedges

• Market cap of gold plus all crypto moves with liquidity almost one for one.

• As QE continues, monetary hedges will increase in value. This means gold and crypto.

• Only two assets can be owned to make money in addition to debasement: gold and crypto.

Potential Dangers

• Last time there was a serious threat to paper money systems (in 1930s), gold was banned by US government.

• There is a danger that governments may try to stop investors from putting money into crypto or other monetary hedges.

• Governments will do anything to preserve their sovereign debt markets, which is why they have been acting as they have been recently.

Fragility of Financial System

• Central banks keep coming back with more liquidity to paper over any cracks in the financial system.

• Credit markets now demand collateral; excess demand for collateral leads to an endless collateral shortage which makes dollar go up.

• There is a fundamental problem with excess demand for collateral in the system.

Fixed Income Markets and Negative Term Premium

In this section, the speaker discusses the fixed income markets globally and how there are two markets worldwide where you see negative term premium. These are the Bund market and the U.S treasury market.

Negative Term Premium in Pristine Collateral Markets

• The two markets where negative term premium is seen are the Bund market and the U.S treasury market.

• These markets have pristine collateral.

Interest Payments in QE

In this section, the speaker talks about interest payments in QE for Japan, UK, and Europe. They also discuss whether central banks made an agreement to monetize interest payments.

Monetizing Interest Payments

• Interest payments in QE worked for Japan, UK, and Europe.

• The speaker thinks that maybe central banks made an agreement to monetize interest payments.

• All balance sheets show interest payments plus anything they have to directly inject into the banking system.

Central Banks' Knowledge on Monetizing Interest Payments

In this section, the speaker discusses whether central banks know what they're doing when it comes to monetizing interest payments.

Central Banks' Knowledge on Monetizing Interest Payments

• The speaker thinks that central banks may be monetizing interest payments because all of them hit 100% of GDP in debt at government level.

• Central banks may be a step behind the markets but ultimately catch up.

• Central banks have moved quickly recently which shows their concern about the financial system.

• Policy makers will avoid a banking crisis at all costs as it's not in anyone's interest to give China a gift by presenting a banking crisis in the west.

Structural Inflation and Deflation

In this section, the speaker talks about their view on structural inflation and deflation.

Structural Inflation and Deflation

• The speaker is fundamentally a deflationist because they think that what the world is going through is a japanification.

• Demographics are a huge factor in this trend.

• Central bank liquidity injections spill over from time to time into the price level which creates volatility in inflation rate.

• The trend in inflation is probably downwards or it's low but there's a lot of volatility in that inflation rate.

What to Expect in the Economy and Equity Markets

In this section, the speaker discusses how equities tend to perform well when inflation is coming down. They also talk about the fixed income markets and how they can provide insight into the state of the economy. The speaker predicts a shallow bottom in the US economy around mid-year and explains why they believe this to be true.

Equities Performance

• Equities tend to do well when inflation is coming down.

• Equity markets are climbing despite concerns about a potential recession.

• Stock markets tend to discount about six months ahead, so the rally seen since the beginning of the year seems on track.

Fixed Income Markets

• Fixed income markets provide insight into liquidity and can reveal potential financial fragility.

• Negative term premia bias yield curves, but they are not necessarily indicative of economic expectations or rate expectations.

Shallow Bottom in US Economy

• The speaker predicts a shallow bottom in the US economy around mid-year.

• Liquidity is driving equity markets, making them a duration play.

• The yield curve is biased by negative term premia, which are more related to potential financial fragility than real economic fragility.

The Role of China's Credit Cycle in Global Growth

In this section, the speaker discusses China's role in global growth and how their credit cycle leads all others. They explain that China has been goosing their economy with big liquidity injections since COVID lockdown ended.

China's Role in Global Growth

• China's credit cycle leads all others and is ahead of the current global growth.

• The Federal Reserve and the People's Bank of China are the two central banks that matter most in the world.

• The Chinese have been goosing their economy with big liquidity injections since COVID lockdown ended.

China's Growth Engines

• There are three engines of growth for any economy: consumer spending, capital spending infrastructure, or export growth.

• China has relied on infrastructure spending and export growth to a great extent.

China's Economic Growth and Consumer Spending

In this section, the speaker discusses the challenges facing China's economy in terms of delivering growth and increasing consumer spending.

Infrastructure Boom vs. Delivering Growth

• China needs to deliver growth in its economy.

• There are few ways of doing that, particularly if the world is becoming more questionable about taking Chinese exports.

• To achieve growth, China may have to devalue the Yuan quite significantly.

Enfranchising the Consumer

• The annual five-year plans in China always say they're going to enfranchise the consumer, but it never happens.

• The reason is politics; if they enfranchise the Chinese consumer, they may want democracy.

• The distribution of income in China is so skewed away from households much more towards state-owned enterprises and the Communist party that they won't give up power.

Challenges with Consumer Spending

• The only thing left for China is to go down the credit route or get on the export route.

• With a rapidly aging population, old people do not spend money.

• Chinese consumers tend not to be big spenders compared with Western consumers in general; they tend to save their money.

Global Monetary Cycle and Liquidity

In this section, the speaker talks about where we are now in the global monetary cycle and how it plays out over the next 12 months.

Bull Marketing Liquidity Started in October 2019

• A bull marketing liquidity started in October 2019.

• We're in the early months of that cycle which will last through until about 2026 according to normal cyclical patterns.

Drivers of Liquidity

• It's not going to be a straight line upwards; there will be difficulties along the way.

• Central banks are now trying to repair or at least tape over the cracks in the system, so there will not be a major banking crisis.

• The driver of liquidity has been a pickup in collateral values and an increase in central bank balance sheets that's come through both from the Federal Reserve and from The People's Bank of China.

Importance of Bond Volatility

• Equity investors need to look beyond the VIX Index which is their traditional measure of risk.

• Start looking at the move index bond volatility; that's what's critical because if bond volatility falls, you're likely to see a collateral increase significantly.

• Central banks have got to get bond market volatility down, and that's one of the things they are doing behind the scenes.

Increase in Liquidity

• Since October 2019, there has been something like an eight to ten percent increase in liquidity from that point.

CBO Estimates and Federal Reserve's Role

The Congressional Budget Office (CBO) estimates a widening deficit until 2033. The CBO acknowledges the rising share of the Federal Reserve taking up treasury debt.

Rising Share for the Federal Reserve

• The CBO factors in a rising share for the Federal Reserve taking up treasury debt.

• QE has not gone away, it is there, and the Federal Reserve has to play a bigger role.

• Treasuries have continued to fall off the balance sheet, but the Federal Reserve has injected half a trillion dollars into the US money markets following SVB's failure.

QT and Withdrawal of Liquidity

• QT is not withdrawing liquidity; it is letting government debt roll off central bank balance sheets.

• TGA getting drawn down ahead of the debt ceiling means that effectively that money is actually a withdrawal of liquidity from the system.

Reverse Repo Market and Debt Ceiling Debate

This section discusses how reverse repo market and TGA are affecting US markets. It also talks about how these issues will affect markets in April, which is normally a big tax season month for the US.

Reverse Repo Market

• There is lots of excess liquidity in the financial system.

• Money funds who are putting money into reverse repo are basically that velocity of that money to put another way is basically falling; it's zero velocity so that needs to be put back in some way.

TGA Drawdown Ahead of Debt Ceiling

• Janet Yellen talked about using reverse repo as one of the tools that they will use at some point to free up the reverse repo market.

• The TGA getting drawn down ahead of the debt ceiling means that effectively that money is actually a withdrawal of liquidity from the system.

Deposit Flight and Rate Cutting

This section discusses how deposit flight is going to keep happening, and it keeps going into the reverse repo via the money market funds or whatever, and how FED are going to have to cut rates very fast at some point.

Deposit Flight

• The issue within the banking system is they've falsely constructed a yield curve by creating a half percent interest, and then they invested it.

• That money is locked up; it's on the FED balance sheet and not circulating.

Rate Cutting

• It feels like cutting rates is inevitable because it's going to be extremely difficult for them to finesse things.

• They've got a mess they've got to face, and you've got this debt ceiling debate which is going on now.

The Problem with Low Interest Rates

In this section, the speaker discusses the problem with low-interest rates and how it incentivizes people to take on more debt. They also talk about the fragility of the financial system and how central banks have to keep supporting it.

Low-Interest Rates and Debt

• The problem with low-interest rates is that they incentivize people to take on more debt.

• Taking on too much debt can lead to financial fragility, especially if it's from the private sector.

• The financial system is not as robust as many people think, which is why central banks have to keep supporting it with liquidity.

• Rates will come down at the short end, but there's no other way of doing it.

Yield Curve Control

• Yield curve control is part of the future because governments or treasuries and monetary authorities are attempting to control the yield curve.

• Governments or treasuries and monetary authorities in recent months have been attempting to control the yield curve in both the US and Japan.

• Yield curve control is coming soon, if not already here.

Looking for Monetary Hedges

In this section, speakers discuss how liquidity has gone from being an important component to being everything right now. They also talk about looking for monetary hedges as alternatives such as gold, crypto, or technology.

Liquidity Importance

• Liquidity has gone from being an important component to being everything right now.

• The correlation between liquidity and the S&P is much higher than it used to be.

Monetary Hedges

• Looking for monetary hedges as alternatives such as gold, crypto, or technology.

Central Bank Balance Sheet and Liquidity

In this section, the speaker discusses how central bank balance sheets and liquidity are important for financial stability. The yield curve is also mentioned as an indicator of the liquidity cycle.

Importance of Liquidity

• Liquidity has picked up by 8 to 10 percent in absolute terms since the October low point.

• Many markets have bottomed, including the crypto space, gold market, equities, and technology.

• The yield curve is beginning to steepen about six months after the first inflection in the liquidity cycle.

People's Perception of Equities

• People are not willing to believe that equities are not going down.

• Traditional economics is being relied on too much when predicting stock market trends. The stock market predicts the economy, not vice versa.

Role of Central Banks

• Central banks can stop a banking crisis immediately by printing money and putting anything on their balance sheet.

• ECB took everything as collateral during a commercial real estate issue that was brewing.

Understanding Liquidity

In this section, the speaker emphasizes that understanding how liquidity drives everything is crucial for understanding macroeconomics. He urges people to start understanding how liquidity matters more than anything else.

Importance of Liquidity

• Until you understand how liquidity drives everything, your models won't work and your price earnings ratios won't work either.

• It seems impossible for there not to be more use of central bank balance sheets in a world where every government is over 100% of GDP in debt.

Conclusion

• The use of central bank balance sheet and liquidity overall is really the biggest force in all of macro.

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