Updated: Sep 28, 2022
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About the guest:
Michael Howell is the founder and managing director of CrossBorder Capital, an independent investment advisory and macro research firm specialized in the monitoring of Global Liquidity Flows.
In 2010, CrossBorder started managing systematic fixed income specialized mandates, and in 2016 systematic currency specialized mandates. In 2018, CrossBorder launched the Quantitative Fixed Income UCITS Fund and currently runs over $1 billion AUM.
Michael is the author of “Capital Wars: The rise of global liquidity” (click here to see the book on amazon) and he is perhaps the number one expert in the world regarding capital and liquidity flows.
Question 1: Importance of global liquidity
Giorgio: In my office, I have printed and hung on the wall two pictures, the first one is your chart of Global Liquidity and World Wealth,
and the second one is a quote by Stanley Druckenmiller that says
“Earnings don’t move the overall market. It’s the Federal Reserve Board. Focus on the central banks and focus on the movement of liquidity.”
So my first question is: How important is it for today’s investors to understand global liquidity? And in which part of the liquidity cycle do you think we are today?
Global liquidity is all that matters. Money moves markets.
One of the keys to understanding markets is to know where we are in the liquidity cycle and understand whether liquidity is going out of the system or flowing in.
Today, the most important drivers of global liquidity flows are the Federal Reserve and the People’s Bank of China (PBOC)
The Bank of England, the Bank of Japan, and the European Central Bank have been long eclipsed and are in the “second row” now when it comes to driving global liquidity.
The Federal Reserve dominates financial markets.
The PBOC, because of its impact on the Chinese economy and the size of the Chinese economy relative to the world, has a greater effect on real economies.
Question 2: The US vs Chinese monetary policies
Giorgio: What’s your view on the US and China right now, given that the US is on an aggressive tightening cycle (raising rates and doing QT) while China is easing financial conditions to stimulate the economy?
The Chinese have kept a tight monetary policy during the last 2 years (during covid) unlike western countries that have eased aggressively to stimulate the economy. The Chinese’s decision of keeping a tight monetary policy in the past months is the main reason why its economy is in bad shape right now.
China has had a policy since 2016 of trying to stabilize the Chinese Yuan Currency. Which is part of their long-term goal to ultimately displace the US dollar. They are trying to create a stable standard of value to which other countries can fix their currencies. They are trying to recreate the role of the US dollar, but in the Asian region.
As of right now, they are failing as the Chinese Yuan is testing new lows against the US dollar.
The Fed’s policy for 2022 has been to bring its balance sheet down and the dollar up. As the dollar rises, it disturbs forex markets worldwide. We have seen how the EUR, the GBP, and the JPY have declined against the dollar.
The Chinese have been trying to “fight” the rising dollar by keeping an unusually tight monetary policy.
However, the fact that they have allowed the Yuan to devalue past the psychological “7” barrier against the dollar probably means that they are accepting (at least in the short term) that the Yuan will be weak. And this may give them a bit of freedom in boosting monetary policy.
We could therefore see some easing in Chinese monetary conditions over the next 6 to 12 months.
The Chinese stock market has been the first one to enter a “bear market” and it may well be the first one to bottom.
The US Federal Reserve has been aggressively tightening monetary conditions by raising rates and shrinking the balance sheet. They are squeezing the economy to try to get rid of inflation.
Looking at the yield curve we can see some warning signs. The 10-year minus the 5-year bond spread is a very good heads up to what’s called “term premia”. As the spread narrows and then goes into negative territory (therefore the 5-year bond yields more than the 10-year bond) it communicates that term premia are negative, which is a warning sign for policymakers and for investors.
Negative term premia warn us that risk aversion is very high. Even though risk aversion is high, bond yields can still rise because the Fed raises interest rates.
Question 3: Term Premia
Giorgio: in a recent Twitter space hosted by George Noble, you said, “the elephant in the room is the all-time low in term premia printed in the bond markets. Icarus has already fallen! It points to a 20% fall in SPX earnings in 2023.”
Could you expand on this concept, and for those who don’t know what Term Premia is, could you explain it and explain why it’s important right now?
A bond has two moving parts:
1) Policy interest rates expectations over the life of the bond.
In other words, if you are looking at a 10-year bond, Investors are estimating what Fed Fund Rates will be during the entire 10 years.
2) The current bond market yield.
The difference between the current bond market yield and the average policy interest rates expectation is the term premia.
If you look at a 10-year treasury bond which is currently yielding 3.8%, and the average expected Fed Fund Rates over the 10 years is 5%, then term premia will be calculated as:
Term premia = 3.8% - 5% = negative 1.2%
Term premia are mainly affected by supply and demand. If you have a big negative term prima (like right now) it tells you that there is excess demand for 10-year bonds. There may be three reasons for this excess demand:
1) Investors believe that there is a big recession coming
2) There is a general shortage of collateral in the system
3) There is a liquidity shortage
Anyone of those three things ought to be a big red flag for investors right now! In 60 years of data, term premia on the 10-year bond have never been lower than right now.
Question 4: Safe Assets
Giorgio: In your book, you talked about safe assets, what they are and why they are important. What do you think are the safe assets right now and is there a shortage of them?
There is a shortage of safe assets.
A safe asset represents pristine collateral:
Something that can be used to borrow against.
It is very liquid.
Everyone will accept it.
You can sell it easily without any substantial loss of capital.
The main safe assets at the moment are US treasuries and German Bunds. The currency weakness seen in the GBP and the JPY has decreased the appeal of UK GILTs and Japanese JGBs.
Question 5: Is gold a safe asset?
Giorgio: would you consider gold to be a safe asset or not?
Gold is not an inflation hedge. Although some people (erroneously) describe it as such. And we can see this relationship right now. Why isn’t gold going up when inflation is at decades' highs?
The reason is that gold is not an inflation hedge but a monetary inflation hedge. So it’s a hedge against the largesse of central banks. If central banks print money, the gold’s price goes up, conversely, if the central banks shrink their balance sheet, the gold price goes down.
So when Central Banks return to Quantitative Easing, buy gold. And equally, buy cryptocurrency (a more levered monetary hedge)
Question 6: Current stage in the liquidity cycle
Giorgio: What stage of the liquidity cycle are we in right now? And how long can Central Banks continue on this path of draining liquidity out of the system before something breaks?
The liquidity cycle has 4 phases.
The low point and the initial pick-up in the cycle = the rebound
The liquidity is above average but still rising = calm phase
The liquidity is above average but falling = speculative phase
The liquidity is below average and falling = turbulence
These states (4 phases) of liquidity precede the equivalent states in financial markets by roughly 12 months.
We are currently in the "turbulence phase" in liquidity as it has plunged in the last 12 months.
In a 6 months view, the liquidity cycle will definitely bottom a be picking up. But it won’t be enough to save markets and you need to expect at least 3 additional months of pain.
The current low level of term premia is indicating that corporate earnings are going to crash in 2023 (see chart below from CrossBorder Capital)
In terms of a timeline, a bear market has 2 down legs. The first down leg, usually a 25% drop, that we already had. Then you get a rally of an average of 10% over the period of 2 or 3 months (which we had from June 2022 until mid-August 2022). And then you get another leg down of a further 15-20% based on decreased earnings. And this is the phase we are entering now according to CrossBorder Capital.
Question 7: Could we see a liquidation phase in markets?
Giorgio: Based on the current state of liquidity in the system, do you think we could see a liquidity crisis like 2008?
The odds of a liquidity crisis are meaningful. Probably higher than 50%. There are areas of the financial markets which look very vulnerable:
Corporate bond market
Question 8: What’s your current investment approach?
Based on the current environment, what is your investment approach? Are equities to be avoided? Is cash no longer trash? And what about bonds, given the fact that the Fed is raising interest rates?
The dollar is still the best currency for now. Having said that, if the authorities are concerned about financial stability they could try to engineer a reversal in the dollar. But until they do, the dollar looks good.
In the bond market, the front end of the yield curve in the US looks enticing (1-2 year bonds). The front end looks safer right now.
Equities are to be avoided as there could be a further 15%-20% downside.
In the next 6 to 9 months there could be an opportunity to go long equity as central banks are forced to start QE again. There are 3 big hints of this possible pivot in central banks policy over the next 6 to 9 months:
China is likely to be easing as we discussed before
The ECB balance sheet is not going to be shrinking as fast as people anticipated
Powell recently said “we will use QE again if it’s necessary”
If the central banks are forced to do QE in the next 6 months, the new liquidity injections will begin to affect equity markets positively.
Equities after bear markets go up almost in a straight line. The average return for the S&P 500 over the following 2 years from a bear market low is +40%.
Question 9: The Euro currency
Giorgio: What’s your view on the euro currency right now?
The euro needs to go lower, probably a lot lower. The estimate is ultimately something like 0.85 against the dollar. The fundamental reason is that the structure of the Euro is fatally flawed because there is no safe asset in the euro system.
The only safe asset is a national asset and is the German Bund. They would need to create a euro-based euro-denominated safe asset, which doesn't exist at the moment.
Every time there is a crisis in the Eurozone, investors buy bunds, and so spreads (between bunds and other European nations’ bonds) widen. To keep the spreads in line, the ECB has basically promised to print money, which will cause the euro to weaken.
What the euro needs to survive is a pan-European fiscal policy. And since it is never going to happen, the Eurozone will always have crises. And instead of the euro currency breaking up, it will weaken against other currencies.
Question 10: Forex interventions?
Given the recent Japanese intervention in the forex market, do you think we will see more interventions in the future? And do these interventions have lasting effects or not?
The yen has devalued dramatically this year. Between March and May of 2022, the Yen devalued at an 82% annualized rate. Markets don’t do these things, Central banks do.
There might have been a deliberate attempt to push the Yen lower. It could have been a joint decision between the US and Japan. And this may have been a coordinated attempt to bring the dollar up and put pressure on China. Ultimately the Japanese will have to tighten financial conditions and raise interest rates, and we are approaching this moment.
As for the Euro currency, could the ECB intervene to save the euro from going to 0.85 against the dollar? Yes, they could, if they tightened financial conditions enough, but it would create a severe crisis and it would cause spreads to blow up. And we know that they can’t let it happen. So policymakers in Europe have their hands tied at the moment.
Question 11: Could we see another Plaza Accord?
Giorgio: In the mid-1980s the major western countries got together and decided to devalue the dollar in what is now known as the Plaza Accord, do you think that we could see another Plaza Accord?
The answer could be yes, even though it probably won’t be something as formal as the Plaza Accord in 1985. They could very well decide to stop the dollar from rising in a coming G20 or G10 meeting.
Thinking in geopolitical terms, looking at the Ukrainian war it may not be in the US’ best interest to see the euro currency collapse. So it may well be that we are getting close to the pain threshold where Americans think about stopping the rise of the dollar.
Currencies are geopolitical instruments. America has weaponized the dollar. And we may be reaching the point in which is becoming too powerful.