all right welcome back to another episode of Ford Guidance and joining me today is repeat guest Michael Howell of Crossboard Capital the the man with the knowledge of liquidity Michael great to have you back on the show How's things well hi Felix Pretty good thanks Yeah but a lot of a lot of things going on in markets right now So I'm sure there's a lot to talk about Yeah Yeah a lot of crossurrens for sure Um super excited to catch up with you There's a lot of moving parts especially within the bank reserve uh system and liquidity as a whole And I I want to deep dive into that And so I'm actually going to take the liberty in this episode of of assuming that my my audience watch I know they have have been regular listeners to yourself So we're going to assume some knowledge there and do a bit of a deep dive in this episode and get into some some pretty unique topics And the first topic that I want to get into today is really around understanding the banking reserve situation at hand and where are we at within it So oftentimes when central bankers talk about bank reserves in the system they use this idea of are we in an ample regime or a scarce regime or an abundant regime We've we've been in a highly ample regime for the last couple years ever since co and as they've been going forth with with QT etc We're getting closer and closer to you know this point where I wouldn't say where it's scarce yet Maybe abundant maybe ample but would just love to hear of yeah where do we sit within this situation of bank reserves as they stand well I think we can we can actually go into detail of where where we think the the limits are and we think we're we're actually very close uh and you know I've gone on record to say that if you if you extrapolate uh what's happening at the Federal Reserve it's quite likely that um you know to put it bluntly the the the money runs out probably this September So we're very close to that threshold that dangerous threshold and if you look at repo markets I mean repo markets are starting to see you know uh widening spreads I mean that's for sure consistently widening spreads uh and that must be troublesome for Federal Reserve policy makers I mean they they've got to be aware of this Uh they say they don't want a repeat of the 2019 uh repo crisis but you know we're we're sort of edging near all the time But what I would say is it's you know certainly part of the story is bank reserve We've you know the financial system has come a long way in the last decade or decade and a half and we've got to start looking very closely at collateral as well and it's the repo market which really brings together uh if you like liquidity and collateral in in one place Uh and so looking at repo rates is is clearly important but you've also got to understand the whole collateral background and maybe the whole structure or shape of the financial system and maybe why uh it's looking dangerous or maybe vulnerable at the moment particularly in the context of a potentially slowing US economy And these are all topics we can address uh if the US economy slows down from let's say circa what 7% uh NGDP growth to something under 4% that's going to be uh you know a heavy weight for credit markets really to bear and uh you know I don't really uh you know envy the prospects of them actually Yeah totally Um okay So Michael maybe what we can do here just to get everybody up to speed is if you could just get us up to speed on what you've called this pump and dump that we've gone through the last couple years of of these these more unique levers that they've been pulling to to make sure that we can get we can float through this this phase towards managing liquidity as a whole To your point it's not just about bank reserves There's also a lot more dynamics about it So okay we're we're getting to this point where we had almost too many reserves in 2021 Um but then we got to this point where they started to do QT but they wanted to do QT without it really affecting the markets too much for a whole host of different reasons that we can get into But yeah what was that process look like and and where does that lead us today and I know you have a few charts that we could look at as well as we go through Okay Well let let me first start on what you've described as the pump and dump which I think is a big big deal and I think it's not properly focused on Um uh it's been aired by the administration something they've been concerned about Uh and this was really activities that Powell and Yellen got up to in 2024 arguably allegedly to try and get Biden reelected I mean clearly that failed Uh but there was a secret or hidden stimulus that went through the US economy Now um I'll talk about that then I'll go on to uh say something about the structure of the financial system why this matters drill into bank reserves and then come back to this collateral question which is another another thing to do Let me just describe what's going on here because it's uh maybe it's not apparent at first sight what it means or what it really conveys What this chart is looking at is in orange there is uh um a region uh measured in trillions of dollars of what we call not QEQE and that is the activities of the Federal Reserve outside of their stated QT or balance sheet uh policy Uh and what I mean by that that balance sheet policy is basically letting treasuries roll off the balance sheet That's how the current FOMC defines QT Uh arguably one would say that by parallel if they were accumulating treasuries that would be under their remitt uh QE It was not how QE was originally envisioned If you go way back to Ben Bernani who said it was all about looking at uh the reaction of bank reserves and he's very clear he's made a very clear statement about that So the goalposts have changed in what the Federal Reserve is talking about but let's get a consistent and clear definition And the orange area in that chart is what I called not QEQE which is activities outside of uh treasuries or NBS securities This is things like the reverse repo facility the the the rundown in reverse repos its fluctuations in the Treasury General account its operating losses that the Federal Reserve makes on its uh on its holdings uh and it's things like which have now defunct the bank term uh funding program So all those factors are part of that orange area So this was liquidity injections that the Federal Reserve was undertaking into the system um outside of their stated QT policy So in other words they weren't really doing QT they were doing a hidden QE hence the name On top of that the Treasury uh very cleverly perhaps uh via Janet Yellen decided what they were going to do was to start to fund the US government through very shortdated teners and bills So something like um over 60% of funding of the US deficit since the end of 2023 uh if my number if my memory serves me correctly uh 60% was in the form of bills So these astronomically high numbers uh from in recent history uh bills are very shortdated government securities They don't pay a coupon Uh they have uh maturity up to 12 months Uh they're loved by banks and credit providers but if banks and credit providers buy these things that's pure monetization uh of the deficit And that really is what's been going on Now the red area there is to show the effect of that stimulus uh on the economy Uh so if you add together what the treasury was doing through this change in the funding dynamics the change in the tenor of funding and you add to that what the Federal Reserve was up to in terms of it's not QEQE the YCC there is uh it denotes yield curve control So this was a subtle way of uh of uh of changing of operating yield curve control Uh what you can see at uh the peak in early 2024 uh that was about $6 trillion though it was a huge shot in the arm for both markets and the economy This was extra liquidity that was flowing into the system effectively Now what you can see over the course of 2024 is that has tailed off pretty sharply So we're now down to under a trillion of that stimulus And it's that second derivative which is really important in terms of understanding the impact both on markets and increasingly on on the economy Now if I show you the next chart which is looking at that same data But here what I've done is to um show it alongside the um Philly Fed manufacturing survey in black to try and show that this is actually having an effect on the economy And what I've done here is to advance that uh hidden stimulus forward by 9 months So this may not be recessionary yet but it's certainly causing a sharp slowdown in the economy And that's something I think we need to understand And if you um start to think about what that might mean what this is showing is an AI based analysis of world GDP growth So this is a daily measure that we put together It comes from putting lots of different data sets into the hopper uh and optimizing through an algorithm but it's things like um currencies of trade sensitive economies Uh it's things like credit spreads It's things like commodity prices etc Um and what it's trying to show is how the world economy has slowed down very marketkedly since the middle of December Now this was really before the tariff hiatus or the debate about tariffs really got off the ground And it would suggest that there was already a slowdown underway in terms of world economic growth prior to that date And I would venture that a large part of that was this decline in this hidden stimulus So this is why we're starting to see evidence of a slower economy and you know the tariff uh you know uncertainty uh is only going to add to that So what we've got is a threat to credit markets potentially coming up Why is that important we can go into that Yeah So I do want to get into the implications of of what needs to happen next in in a second but I do want to clarify a few things before we get into that Um so if you go back to that first chart that you just mentioned there when you use these these definitions of of not QEQE not yield curve control yield curve control um what I assume is these are shorthand definitions to say effectively we have fiscal and monetary duration management it you're not necessarily saying this is you know large scale asset purchases you know we had a few weeks ago Powell was on testimony at the Senate where you mentioned you know we won't see QE until rates are at zero at the very least and I think that confused a lot of people because there's also this discussion of you know QE needs to happen soon you you've mentioned a few things happening so I just want to really clarify you know when you're saying that as we get forward into the conversation here that some version of duration management needs to occur are you saying outright quantitative easing where you know that the Federal Reserve is is buying bonds from the sec secondary market and swapping them for central bank reserves or is this something more along the lines of a BTFP type facility that allows them to to manage the duration but it's still a loan facility So just want to clarify what exactly do we mean here when we talk about these definitions Let's be clear what I'm saying is that what we need is more liquidity into the system Uh and that basically means an expanding I mean our definition of liquidity uh is essentially the balance sheet capacity of the financial system Okay that's a a crude a very wide broad but a basic definition And the reason that's important is that we live in a debt uh a debt driven world Debt dominates everything we do There is huge amounts of debt that need to be refinanced every year Okay capital markets today are not about new capital raising for for for uh investment projects They're all about rolling over existing debt And if you're going to roll over existing debt what you need is balance sheet capacity And that balance sheet capacity is determined by the as I say the financial sector But the financial sector uh its growth or its expansion is governed by what central banks and regulators are basically uh determining or what they're suggesting If the central bank itself is shrinking its balance sheet it's extremely difficult for the financial sector to expand its So the Federal Reserve needs to step in and expand its balance sheet And one of the things that you can see and I can demonstrate this with a chart quite easily is that if you look at the long-term history of financial markets what this is showing is this is the ratio between advanced economies debt um relative to global liquidity or the advanced economies liquidity Now this is a much much more meaningful statistic than what I would say is the speurious figure that's often thrown out which is debt to GDP Now debt to GDP is probably looked at because it's convenient and easier to me easy to measure but like many things in in economics uh those things which are easy to measure take on inflated importance when in actual fact they they're irrelevant and debt to GDP doesn't really mean very much in my sense What you need to look at is whether that debt can be refinanced And therefore what you need to look at is the debt to liquidity ratio in the economy Now what this ratio shows here is the history for the advanced economies of debt to liquidity And what you can see from the dotted line that we've drawn on that there it is an equilibriating or mean reverting relationship And if you try and test this statistically it comes out uh you know unambiguously This is a mean reverting data series and it can it mean reverts at a roughly speaking uh 2 to one So you know twice as much debt per dollar of liquidity If you have uh too much debt relative to liquidity and I've annotated the chart correspondingly you tend to find at the upper uh reaches of that chart financial crisis I would venture that every financial crisis in the last 30 years or so 40 years has been uh a debt refinancing crisis in some shape or form When you get the reverse when the debt to liquidity ratio is very low in other words when there is abundant liquidity in the system you get asset bubbles Now let's look at where we where we're starting from Now we're starting from a period where we've seen uh you know something like 10 years uh at least of uh a very depressed debt to liquidity ratios Now why is that uh number one reason is that central banks threw an awful lot of liquidity back into the system uh in the wake of the 2008 GFC understandably because the financial system was struggling at that point with their balance sheet and then they added more during the period of the co emergency as we know that was an abundant liquidity injection and it forced the debt GDP ratio lower On top of that zero interest rates as were enacted through much of that period incentivized many corporations and even governments to start to term out their debt So what they did is they they basically borrowed at low interest rates and that terming out of debt the so-called debt maturity wall is coming back to haunt investors over the next two to three years And that's why if you look at that chart you will see that the orange line in the projection period is starting to go almost near vertical And that's because a lot of that turned out debt is coming back Now this is enough to end the bull market by definition It may not be enough yet to cause a bare market but clearly one's eyes have got to be very closely on the ball here because one slip could be a serious issue And central banks need to be alert to these balance sheet questions And as I keep stressing we're in a debt refinancing world where balance sheet matters We're no longer in a capital spending world where interest rates on the cost of capital are paramount It's not about interest rates it's about balance sheet And I wish policy makers would start to realize that Hey everyone this episode is sponsored by Ledger For the past decade Ledger has been the global leader in digital asset security Trusted to secure more than 20% of the world's crypto assets Celebrating 10 years of innovation Ledger is making digital ownership more secure and accessible with their latest products Ledger Stacks and Ledger Flex These wallets feature the world's first secure touchscreens simplifying your digital transactions while ensuring uncompromising security through his Ledger secure chip and proprietary OS Plus with the Ledger Security Key app you can say goodbye to traditional passwords and step up your digital protection Your entire crypto experience got a whole lot easier Ready to protect your assets choose the most trusted name and hardware wallets Ledger and take control of your digital security today at leger.com All right back to the show Yeah Um Michael something that really piqued my interest that you wrote about last week and which is why I I you know fervently rushed out to get you on the show here is mechanically and quantif quantifiably understanding this idea of a balance sheet expansion that it needs further assistance from monetary policy i.e some form of of QE or something like that So let's just unpack this here a little bit So in your report that you wrote last week you had mentioned this idea that there's this static balance sheet growth in a way So if we just quantify it by say okay if nominal GDP is running at 5% I think is what you had in there but debt is growing at seven or 8% every year Can you just explain this idea that you know we we've seen a few charts We've seen projections from you know the CBO and even like monetary policy makers where they they anticipate bank reserves to increase in the coming years And I think that causes a lot of confusion because they assume oh you know the Fed is is saying that they expect to do QE in a couple years And we can get into the semantics of it but my understanding of that is that is related to the static balance sheet growth that you mentioned in terms of it it tracking the growth of of of nominal GDP primarily through the growth of interest on reserve balances because you know the Fed is paying that out every day So if you assume that that covers that 5% but what you're saying is debt is growing by seven or eight% a year is the spread between those two numbers what you're saying needs to be covered by the Fed i.e through something like QE or or a different loan uh facility I I would love to get into the specific semantics of what you think is required there Um and why is it that the private sector can't be the ones to relever and cover that why does it have to be from this outside government source okay Well let let me let me go down this road So the first thing to say is what is the likely growth uh of debt over the medium term and let's just take the government as a lead here and let's assume that you've got an interest bill of circa 4% Now we know interest rates are higher than that but actually a lot of government debt is embedded at lower interest rates So the average interest bill is sort of converging towards a figure of about four to four and a half% uh given current interest rates So let's take a figure of 4% which is practical On top of that you've got a deficit Now uh the deficit's clearly been 7 to 8% in the last 2 or 3 years Let's assume that comes down That may be a heroic assumption Let's assume that comes down to about 4% Uh and that's even disregarding recessions And we know in recessions in the past the US fiscal deficit has blown out enormously But let's put that to one side So let's assume it's 4 plus 4 which is 8% So what you've got is debt compounding at 8% If you take my rationale that liquidity has to match the pace or match debt So liquidity growth and debt have to grow uh pretty much together You're talking about 8% growth for liquidity Now that's liquidity for the entire system And then you would expect if b if regulators and central banks are controlling the system then we've got to have uh the ability for the central bank balance sheet to expand par pursue uh with that uh expanding uh liquidity global liquidity uh picture or US liquidity picture The fed has got a key place for that in a steady state So you would expect that the fed balance sheet should be growing at about 8% peranom or that sort of figure Now the fact is that it's not at the moment and what's happening is that bank reserves are kind of stuck at low levels and I think that's where you start to get a problem Now we can fix on that in two ways One is I can show you a chart which describes the structure of the world monetary system which I'll try and do here and this may be a little bit complicated but let me just try and run through some of the basics Now this is my interpretation of how the world financial system works post GFC And what you've got there is a pool of global liquidity at the bottom And that pool of global liquidity really uh depends on collateral Now where collateral and global liquidity meet uh the sort of nexus or um or the sort of choke point is the repo market which I put there in the center Collateral essentially comes in two forms One is public debt instruments which is really uh you know the area let's say uh are thinking about traditional banks which hold all of that stuff and then you've got shadow banks on the right hand side on the upper uh that upper circle uh who tend to use not only public debt but they also use private debt instruments such as uh collateralized loan obligations for example as well Now one of the things that's happening is you're getting this shift from the lefthand side to the right hand side because of regulatory arbitrage And what that really means is that the regulators have got their paws on the banks or their hands rather bank's throat so severely that effectively the system the credit system is migrating uh from the leftand side to the right hand side There's more and more shadow banking activity going on Is that because of things like the SLR ratio that are allowing all these sorts of things are basically making it very difficult or unprofitable for the banks to basically operate through their their own balance sheets So these things are effectively migrating to other to other uh credit providers or they're basically migrating uh off balance sheet of the banks Now what I've tried to say on that diagram and you can look at it in more detail later but effectively what you've got are two means of control in the system One is you've got lender of the last resort which is basically traditional central banking which is providing reserves for the banks and that goes up the sort of the left-hand channel Uh that area traditionally been because it's it's been about looking at investing in safe assets that's sort of been deviation suppressing So in other words that the cycle tends to be attenuated by those activities Then if you look at the right hand side what you've got is uh kind of a new function in a way You might say this is the the central banks or the central bank stroke treasury trying to act as dealer of the last resort and trying to preserve or maintain collateral values and collateral values are clearly important Now the difficulty that the authorities have is that the more you shift from left to right and the more that the system tends to leverage up or uses collateral private debt instruments the more that they're really outside the scope of the normal safety net And what you can find is that that becomes a deviation amplifying in other words very pro- cyclical process and that's the danger we get into So what we've got to start to think about is what is the integrity of that private sector collateral because that is not wholly backstopped by the authorities and that's the danger Therefore if you get a slowing economy you can actually get a negative feedback coming through into the financial system uh which causes potentially a cascade downwards And that's the threat That's what we saw in 2008 I'm not saying we're going to get a 2008 now because you know everyone's a lot smarter But you know we've got to be alert to these risks And you know if you start to look at these problems uh to look at you know the threats that are being imposed this is what's happening in terms of the repo markets Now this is looking at one of the ways to judge tensions in the repo market It's one of several uh indicators one can look at but this is a pretty direct one This is looking at the difference between sofa rates um which is basically the key repo rate in the system minus fed funds the fed funds target And what I've put on that is two tram lines Those two tram lines are indicating where you would expect the normal spread to be And this is what's happened If you can make out where 2024 and 2025 are they're basically on the right hand side of that page Now what that's saying is there's a tremendous amount of bunching particularly in the last six months which is showing sofa rates exceeding Fed funds And that is suggesting that what you've got is problems in the repo market It's either a shortage of high quality collateral or a simple lack of liquidity But the market's starting to break down And this is this is the heartbeat of the system So this is why it's kind of dangerous right now Yeah I I'm glad you brought this up because I did want to follow up to your to your point There's a lot of different ways to measure bank reserve stress and and this is one of them And and to my understanding most of those big spikes upward are around end of quarter when when those dynamics get strained And something I want to bring up is just to understand this timeline of when this stress is going to occur because to your point yes the first time that this will start to show up in terms of strains will be at these end of quarters We've seen a couple times where the Fed has come in and and tried to lift up their their standing repo facility that they have there but tried to allow that to make sure that these bands stay within within check But you know so far we haven't actually seen that much uptake in the standing repo facility in the discount window So I just want to understand the timeline because obviously you're correct that this is this is where it's going to start is these end of quarters but we're not at the point where they have to go to the discount window or to the standing repo facility every day to get reserves Are you just saying that we're seeing the beginnings and this is going to accelerate into the fall well what I would say Felix is that this is not where it starts This is where it ends Okay Um you know this is where you start to see it The trouble is with this indicator is it's not necessarily a pressing indicator unless you look at the trend in it What I'm saying is it's kind of worrying to me that you've got this bunching going on uh in terms of uh uh of potential stress or tensions in this market Now if you look at this chart which is probably the more meaningful one to look at and let me just try and uh you know articulate what goes on here So basically what I've got is there are three lines on this chart and there's a little window that I'm going to explain in a moment The orange line is US banks reserves Now US banks reserves effectively is uh a pretty good way to measure uh money money market liquidity if you or sorry money cash in the money markets I should be saying So it's it it's pretty much equivalent And what this is basically telling us is that what you've seen uh over much of that period uh certainly since the middle of the of the graph is a flatlining of bank reserves Arguably you could say they've trended upwards and at different times they clearly jumped and you can see one specific jump which is the SVB crisis uh where um you know there was a a clear uh increase in in Fed liquidity and consequently bank reserves The line that's below that the darker red line is a one standard deviation uh displacement below that line to try and capture the tail of the distribution of bank reserves between the major banks and the smaller regional banks And this is an inexact way of measuring it but it's really one way of trying to understand where you may be getting problems Uh and that's why we've drawn it Yeah I think it's really important to show that to because bank reserves are very uneven between the large JP Morgans and the small commercial banks So I think that's really great to have that lower bound for that Exactly Now what I've then done is to try and estimate what is the a the average excuse me adequate reserve level in the system or minimum reserve level by that dotted bright red line And that is estimated from the little regression chart that you can see there And that regression chart basically looks over time at how bank reserves have evolved or the target level of minimum bank reserves The first five or six observations have directly taken from the Federal Reserve and the latest observation is one that we estimated looking at where you start to get repo market tensions So that's really what's gone into those estimates And what I've done is I've drawn that adequate or minimum reserve level tangential to the uh lower bound or the one standard deviation displacement to try and indicate where you may get tensions And there was a step down in that uh in that level uh in August of last year when the rules changed for bank stress tests Clearly there could be a step down again uh if they change the supplemental liquidity ratio That's another possibility But these are one-off changes And what this is basically telling us is that if you project uh bank reserves forward uh through the end of this year taking into account things like the debt ceiling taking into account the rundown and then subsequent building up of the Treasury General account assume that we're we've got a little bit more to run off in the reverse repo uh facility We know that the bank term lend uh funding program has ended etc you've got operating losses continuing But you add all those things in and you add seasonality in the TGA what you find is that you get the picture that we depict there Now the dip down uh that you can see is basically uh to do with uh the April tax bill season uh that pushes reserves down because it takes money out of money markets Then there's an increase in bank reserves because the TGA has run down further uh assuming the debt ceiling is not resolved quickly And then in the second half of the year what I've assumed is you get a rebuild of the TGA and I've added in there as well uh seasonal effects in the TGA And basically what you get is that profile So it looks to us that sometime around September uh of this year you get a problem Bank reserves get below that threshold So what you would what you would assume is that repo market tensions start to build So these are things that we look at because we're looking at quantity fundamentally Uh in other words the quantity of liquidity in the system not um uh we're not looking at uh interest rates or trying to predict rates in that regard Uh this is the main focus Okay that is a really excellent characterization of of the situation at hand I think it's really important to show that yeah what you have on here is is the TJ draw on that we're seeing right now and then the ensuing rebuild which is obviously something that the Fed is concerned about right now That's why they paused or you know hinted at pausing QT they haven't fully paused They're still running down NBS and I think 5 billion of treasuries but it's top of their mind So okay everything we've talked about which is that the levers that have been used for the past four years So yeah RRP coming down that's nearly at zero There's some you know quarter end stuff happening right now but that's on its way to zero The TGA is going through what we just described A lot of these levers have been pulled So we get to this point now that you're characterizing which is that something else needs to come in So let's let's get let's understand what actually needs to come in here So you know this is where it gets I think a bit bit complicated I want to be clear on on definitions of here is okay we need bank reserves to go up for liquidity to improve to you know further leverage to the shadow monetary base that you you described earlier in that chart of that dynamic So what needs to come forth here is it actual quantitative easing where the Fed is buying bonds from the secondary market is it you know some sort of specific localized you know short-term loan facility like the BTFP is it elevating the standing repo the standing repo facility further is it the SLR what needs to actually happen here from here on out well there's there's not much juice left in the reverse repo facility It could come down a bit more for sure but that's not really going to solve the problem uh you know what we what we're really talking about here is a situation where uh the Federal Reserve's balance sheet has to grow consistently and I used a figure of 8% peranom over the medium term that's a steadystate growth rate uh and that's what they should be aiming at so all this talk about reducing the size of the balance sheet getting it back as a percentage of GDP or getting it back to historic levels is completely mad in my view I mean what they need to do is In a debt-driven world where we accept the fact that debt is continuing to grow you've got to have balance sheet capacity growing alongside to get the refinancing Otherwise you get a financial crisis And as I would say every financial crisis that we've witnessed in the last 30 or 40 years has basically been a debt refinancing crisis And then central banks are forced to come in to bail the system out Now what I'm suggesting is unless um something happens relatively quickly and I'm talking about through the rest of this year they're going to have to come back in size to bail the system out again because you get another failure Uh and clearly we want to avoid that So what the Federal Reserve should be doing is going back to a QE process uh as soon as they can Now you know I'm you know I've been in this business long enough to know that they're not going to call it QE They're going to disguise it and call it something else So the acronym department of the Federal Reserve will be working overtime burning the midnight oil to come out with something else Uh you know could it be QS quantive support i don't know But they need to expand their balance sheet It used to be called open market operations in the old days but you know maybe maybe we've moved on from there What you're saying is effectively that you know there's there's two things I hear there that the Fed wants to normalize their balance sheet They want to get duration off their book and have the duration match basically like short-term bills like it used to be pre208 and they don't want to do QE before rates are zero What you're saying is both of those goals are unrealistic within this highly debt driven economy Yeah I mean why why does I mean this is equal equally madness Why does the Fed Federal Reserve want to do a major duration dump on the private sector when the private sector you know it's it's madness This is taking liquidity out of the system Now you know cynically and a number of people have suggested this that the Fed Federal Reserve is being mischievous here deliberately and they want to somehow crash the economy uh because they don't see eye to eye with um uh with the with the administration I mean that would be full high I don't I don't subscribe to that but clearly there are there are people who are talking that those words Hey everyone this episode is sponsored by Ledger For the past decade Ledger has been the global leader in digital asset security trusted to secure more than 20% of the world's crypto assets Celebrating 10 years of innovation Ledger is making digital ownership more secure and accessible with their latest products Ledger Stacks and Ledger Flex These wallets feature the world's first secure touchcreens simplifying your digital transactions while ensuring uncompromising security through his Ledger secure chip and proprietary OS Plus with the Ledger Security Key app you can say goodbye to traditional passwords and step up your digital protection Your entire crypto experience got a whole lot easier Ready to protect your assets choose the most trusted name and hardware wallets Ledger and take control of your digital security today at ledger.com All right back to the show Yeah I do think that brings up a good point of you know the level underneath that idea of potentially crashing the economy or whatever is this idea of this debt refinancing wave that you just mentioned here So you know if you hear the Scott Bessant side of the argument which is that we want to get you know we want to get the long bond yields lower We want to recalibrate the economy towards the private sector but really specifically it's this idea of trying to get long bond yields lower And then when you think about the composition of debt as it stands right now you know he's he's got a tough job that he just adopted from Yellen right you know he's she was issuing bills like crazy So if he wants to refinance all that that short-term T bills into longer duration debt how do you think about this needed debt refinancing do you think it's enough to you know take a haircut of 20% on equities get the 10-year below four you know low threes or something like that repivot all these bills into longerterm debt and then you know head on into the distance like how do you see this debt refinancing wave start to potentially happen i think I think it's really really tricky Felix And I think you know it's the uh it's like the old Irish joke is if you want to travel to Dublin uh don't start from here And um you know that's that's the problem they've got Effectively the legacy of of Yellen with for Scott Besson is a really bad one Uh he's got a very very difficult situation uh to manage He's a very smart guy and I'm sure he'll come up with a solution But the fact is he's sort of boxed in I mean he can't really uh issue a lot of coupon debt now um without disrupting the markets significantly as far as I can see He probably doesn't want to create an economic slowdown Although in many ways I mean if a slowdown occurs that could be welcome because it may ease the funding burden because it will it will cause yields to fall back But you see the problem you've got is if you start to look at this in an international context that the US is in a more tricky situation than it was a decade ago because there are not that many international or there are fewer I should say international buyers of US government debt than there were a decade ago The Chinese have stepped back The Japanese don't seem to have the same appetite you're really relying on offshore hedge funds to do a lot of that and that really comes through the in something called the basis trade that you will be well aware of So you know how can they find uh you know foreign buying and the problem is if you look at the foreign markets term premier that sort of wonkish concept that tends to dominate the bond markets uh and contribute to rising yields term premier are actually increasing and they're increasing because deficits around the rest of the world are increasing The Chinese say they're going to increase government bond uh issuance Uh the Germans we know are And this chart which you've just put up is basically illustrating the backdrop in the US Treasury market Now if you look at that the uh the orange line is basically the 10-year yield And I've put on there you know what I what I see are the sort of the trend lines of indicating where the where the market's trading Uh I mean you could argue that there are maybe there's a different channel unfolding now which is maybe more more horizontal but you know arguably um that's the picture for yields and if but if you look at the black line at the bottom that's term premier on our estimates daily term premium that's trending higher So what you've got in prospect is if the economy slows and the Federal Reserve is forced to cut interest rates there's a pronounced steepening of the yield curve likely uh and that's that's maybe something that's going to occur and that might give you know Scott Besson the facility to fund around the mid- duration area Um but you know forget longdated coupons as far as I can see Yeah Um that brings up a good segue into how all this you know liquidity monetary plumbing talk starts to affect other asset classes in markets So you've had some really interesting analysis of effectively this yield curve suppression which I think is is a really important concept as well Um I would love for you to just explain that a little bit of of how did you mechanically unpack the idea that you know if if you if you extrapolate the the the yield from mortgage back securities as opposed to the traditional you know US Treasury like you know the par curve or something like that Um what does that mean that we've actually been suppressing the yield curve and how does that actually reflect in the markets you had a really interesting analysis of how that actually had a second order effect on break even inflation rates which makes it understated So we'd love for you to just unpack that idea Yeah What what that's saying is that if you if you look at the mortgage uh the the the mortgage market the mortgage market or MBS securities are basically government governmentbacked um and central banks um even the Federal Reserve holds mortgage back securities and deems it a risk-free security Now the difference between a mortgage backed security and a US treasury is that a mortgage back security has longer duration and it has to use another wonkish term more convexity than a normal uh conventional treasury And so what you can do is mathematically because bonds are all about maths is you can basically bring the mortgage back securities back to an equivalent u duration and convexity as a normal treasury And that's what we did in in an we did that as an exercise And if you look at the difference between um a bootstrapped uh 10-year Treasury from the mortgage market and the actual 10-year Treasury the difference is about 100 basis points In other words the actual Treasury is trading 100 basis points cheap to the bootstrap version And if you do a an analysis and it's I haven't got charts on this here but it's all in our research If you do a comparison between that gap in other words between the bootstrap version and the actual yield you find that it correlates extremely closely with bill issuance So when the when Janet Yan poured uh funding towards bills uh what that caused is a big deviation in the spread between the bootstrapped and the uh actual actual 10-year yield simply because there was a scarcity of coupons in the system And that's what happened Now what are the what are the consequences of that the consequences are that if you lop a 100 basis or sorry big pun if you add a 100 basis points to the 10-year yield the yield curve over the period from 2023 onwards has never inverted Okay so there was no signal of a recession So the recession call was a false flag because the Treasury yield had been distorted Secondly if you look at the tips market and you work out what break even inflation rates are you find that actually break even inflation rates should be 100 basis points higher Well actually lo and behold if you graph that against the University of Michigan survey what you find is that that adjusted uh break even inflation rate moves much much more closely with the uh University of Michigan consumer survey uh than anything else than certainly than the uh published break even numbers do So what it's saying is there is higher inflation in the system uh and the economy never got anywhere near recession despite the calls of of many economists in the last two or three years Look forward it may be you know we may be seeing another slowdown in the economy coming up but if you want to bet in a recession you know bet forwards not backwards Yeah I think this is one of the most important concept because when you think about it like all discount rates are based off the 10ear So if we're if we're using the wrong rate this is like huge So I I have a couple questions for you on that point which is one how does this dislocation solve itself and why like is my understanding is that was largely caused by this scarcity of duration coming onto the market not QE specifically because we've had many years of QE before but we never saw such a dislocation so it's is it mostly because of that you know activist treasury issuance policy that Yellen pursued exactly it's the it's the noty yield curve control yield curve control dimension right rather than the not QEQE Exactly right Yeah that that's true How does it resolve itself it resolves itself through term premier rising and on most estimates uh term premier are negative or certainly have been negative Our estimates are still negative We have a different uh take uh than than maybe some of the other models but uh our numbers show still negative term premier and that term premier as we indicated is rising The other question therefore uh which comes through this is what happens to the credit markets and you know what are the implications here and I think that's you know that's clearly something which is uh uh you know of import given the fact that you if you look at the triple C u you know uh the triple C bond corporate credit that ended last quarter at 13.2% It's jumped 200 basis points pretty much since early January and the these are pretty sizable moves coming through now So the credit markets are are deteriorating This is something which is quite interesting which is maybe a precursor to this in the way that we understand markets There are two dimensions One is the flow of liquidity and the second thing is the deployment of that that liquidity into risk assets Now from everything I've said so far liquidity isn't declining uh it may be slowing in its momentum which is clearly something of concern But what is actually happening as well is the other dimension if you like the other blade of the scissors is actually deteriorating faster and that is looking at the what we call the world risk cycle This seems to be about a 9 to 10 year cycle and it basically shows how investors deploy uh assets in their portfolios split between risk assets and safe assets Now what I've shown on that chart are two lines The orange line is the US for US investors and the red line is for world investors Uh so the US is clearly a subset of the world here But what it shows is a very sharp deterioration through this quarter in the risk appetite of US investors in particular and the question that I've posed is why is that going on now some people may say it's the uncertainty over tariffs That's you know that's possibly true Then you might say well okay why isn't the world deteriorating faster and my view is it's because of the US economy deteriorating and I think it comes back to this uh slowdown uh in the hidden stimulus that I've been articulating Now if we then go on to what's happening in the credit markets what you find is this interesting chart and this tap me back to the time that I was at Salomon Brothers U and a key indicator of one of the risks uh in the bond markets and particularly a risk for the credit space Now what you see here is the orange line is looking at the spread between single B and AAA corporate securities and you know clearly that credit spread is an indication as it widens of tensions and potent potential default risks and what I put on top of that is the convexity in the yield the treasury yield curve Now that convexity is simply a measure of how much the 5-year uh bond uh basically trades in yield trades above the average of the two and the 10 So it's basically what's called in Palmer's a butterfly spread but it's a measure of convexity And one of the things that I learned during my time at Salomon Brothers was to say if you start to see spikes in convexity it's normally a heads up to a deteriorating economy and deterioration in the credit markets and this is what you seemingly are getting So you've had this upward spike in convexity and you're starting to get deterioration now coming through in terms of the credit space The next slide is looking at uh another way of analyzing the credit space which is to say well okay let's go back to our old friend the mortgage market uh which is basically shown here for 30-year mortgages in black Uh now even appreciating the fact that these have higher convexity and longer duration than uh than corporate credits corporate credits are probably nearer five to seven years in their uh duration uh even making that allowance what you're getting is credits trading through uh mortgages and mortgages are governmentbacked securities So this seems to be again remarkable that what you've got is is this has never really happened and even if you squint back to 1979 it didn't really happen then I mean the the two lines look close but they never actually got they never intersected uh and what you're looking at now is that is that feature So it looks to looks to us that the credit markets are really priced for perfection in a world where you may not be seeing a US recession but you're seeing normal GDP growth slowing from about seven what maybe at times 8% down to perhaps sub four And that will be difficult for the credit markets to stomach without uh tensions rising And this is why given the credit market's uh role within the global financial system and the fact that they do sustain collateral is why the central banks need to be alert to this deterioration Yeah Um Michael this point that credit spreads which you know are effectively a reflection of probability of default at at any given time And this is something I've actually wondered a lot and it's a random question but you know you know a ton about you traded bonds forever in fixed income Um I'm trying to figure out why are credit spreads priced for per perfection why are they so secularly tight and I think a lot about back in 2020 when the Fed came in and bought commercial paper and I think that surprised a lot of people and I wonder now is that ever since then have credit markets have to price in this idea that the Fed if if things get bad enough the Fed will buy commercial paper and that's why credit spreads remain so tight Have you thought about that much yeah it's a it's a it's a very good reason a very good rationale and I think there there's there's there's mileage in that Felix I think the other thing is that because a lot of corporate debt was termed out um you know there there's not that much around in terms of uh what people can buy So there hasn't been a lot of new issuance for example relatively and that may be another reason why you've got yields are so depressed and certainly if you do I mean the other way to look at this is although I haven't got a chart here but you can see it very clearly is to chart the ISM um the purchasing managers index the PMI for the US against credit spreads and if you look at that that relationship it's basically one for one until the last five years or last four years uh and then you see a big disconnect where the ISM has hardly moved up but credit credit spreads have really come dramatically lower and that just doesn't add up So you know something very odd is going on and I suggest this is supply and demand factors again and it's because there's a scarcity of of issuance Yeah that makes sense too Um okay for the last part of the conversation I want to shift gears a little bit here and talk about China and talk about gold because the way you think about those two seems quite interwoven together So you have some really interesting charts in here looking at what is the state of of China as it stands So you know when I think about the last few months is this characterization that the dollar was very strong into the leadup of the Trump election and that was happening at the same time that China was going through a pretty significant deflationary shock and and and you know potential outright recession And because of that there was a lot of expectation for them to come out guns blazing with with monetary and fiscal bazookas but it really wasn't moving the marker like many investors hoped for Now we're at a point where the Dixie has come down a lot and I would love for you to just update us on how are you thinking about China as it stands today within that context So the the first thing to say is that although you may cynically say that Scott Besson would favor a recession or a slowdown in the US the Chinese definitely don't They want uh a stronger economy So what they're what they're enacting now is a significant change in Chinese uh economic policy monetary and fiscal Now the way to see this or way to to start this is to look at what happened um at the end of 2024 And the graph I've got in front of you is to show in orange uh the yield on the Chinese 10-year bond And look at how that bond collapsed at the end of last year And this was basically in the wake of uh Trump's election Uh it there may have been concerns understandably about tariffs in China but this was fundamentally because the Chinese central bank put its foot very very firmly on the break to basically hold the yuan up up against what was then a very strong dollar So the dollar surged in the wake of the election as we know the DXY you know hit close to probably touched 110 on the index or got very close to it and basically what you saw uh was potential weakening across other crosses and in particular the remmbb came under a lot of pressure which caused the Chinese authorities to really tighten hard Now what that did is it threw the Chinese economy into a tail spin It went it suffered debt deflation again China as we know has a big debt burden and investors fled towards the safety of government debt They went into safe assets They shunned risk assets and look at the scale to which that uh yield on the 10-year bond plunged Okay this is something that you don't see uh very often You certainly don't see over a short space of time This was a panic going on in China This wasn't about interest rate expectations changing It was about term premier falling and I put the term premier graph underneath just to show that the bulk of that move was basically a fall in term premier which was basically saying that investors were rushing for safety What you've seen since then are a number of features One is we know the dollar has softened That has given the opportunity for the Chinese to ease But on top of that uh there has been there have been statements coming out of uh the hierarchy in China Z Jingping uh has basically said you know he's given a pro- capitalist speech He's actually wheeled Jack Mah in uh to applaud him from the front row And you know I've been in Marcus long enough to recall what happened in 1992 uh when his predecessor Deng Xiaoing uh went on the celebrated southern tour to espouse the virtues of capitalism uh in the capitalist regions of southern China And you know he came out with a statement uh to be rich as glorious And this is probably akin to that in a way maybe a watered down version less explicit but we're going in that direction And what this is saying is that China is refueling itself Uh what you've seen is the bond market has recovered dramatically in yield terms There's been a huge bounce in yields That has been a term premium move as the black line says And that's now reversing out of safe assets back into risk assets And that's where the Chinese market is flying Now if we take a look at this chart this is looking at the net liquidity injections of the people's bank And what I've done here is to look at seasonally adjusted uh rolling 3 month total uh to try and uh you know to get through some of the noise that you inevitably get in the Chinese financial system this time of year because of the changing Luna New Year holiday But what it shows is that an annualized rate uh they are injecting something like uh you know 20 uh 20 uh trillion yuard into the system and if you divide that by what 7.25 you can see that's getting to something like 2 and 3/4 uh trillion dollars of net stimulus So these are sizable amounts of cash that the Chinese are throwing at their system That's kind of equivalent to what happened in the US after the GFC So we're on that page This is really important Take a look at Chinese real estate prices uh as published by the BIS They're starting to they're starting to strengthen So all these things are important Now one of the things that I've tried to uh argue uh over the last few years is that what you've got to watch is not the US dollar u uh US dollar yuan or the remmbbe yuan cross rate but to actually look at the remmbb gold price In other words that's the important factor Now what I argued is that to get out of its debt deflation China needs to get the yuan gold price up to about 26,000 yuan per ounce Okay uh that is equivalent at current exchange rates to about $3,600 uh US per ounce Now hold that thought Why are they trying to do that because under a debt deflation the only way to get out or dig out of a debt deflation is to devalue your paper money And the reason that China is in this bind is because the debt liquidity ratio of China uh think of what I was arguing right at the beginning for the advanced economies But China's debt liquidity ratio is currently about 30% or was 30% too high So what they've got to do is to basically print enough liquidity monetize in other words create monetary inflation to bring that ratio lower and that ultimately devalues debt Now what's the best benchmark against that it's not the US dollar yan cross rate It's basically devaluing paper money against a real asset And a real asset is gold So if the yuan gold price goes up by 30% uh from where we were arguing which was basically around uh late 23 early 24 uh if you see a 30% rise in the yuan gold price towards this 26,000 target then you know you're some way to getting out of digging out of the debt deflation in China and that is exactly what's going on So while everyone's been focused on the yuan US dollar even the the people's banks seemingly behind the scenes you've got this process going on now there in lies an interesting uh debate because you could equally fire back at me and say well does the do the Chinese really control this uh you know surely uh you know we've got a dollar gold price we've got a yuan uh US dollar cross and you triangulate that back into u yuan gold price but just think of this process being reversed first Maybe it's no longer the London gold market which is driving the gold market Maybe it's the Shanghai gold exchange which is doing it And if the Shanghai gold exchange is setting the yuan gold price and you hold that uh 7.3 or 7.25 yuan dollar cross then you triangulate the other way into a dollar gold price of 3600 Now clearly there's going to be an argument both ways Some say it's Shanghai some say it's London but I would say the argument's been our way for the last few months Gold is rising No one can seemingly understand why The Chinese are buying lots of gold China is a big hoarder of gold China is the world's biggest gold producer Doesn't this make sense for them to do this michael how do you think about all the gold that's you know when you talk about this the first thing I think about is in recent months we've just seen an obscene amount of imports of gold into the US So much so that it's completely blown up the Atlanta Fed GDP now forecast where they have to gold adjust it just because of the amount of gold that's been imported into the US Does that is that relevant to any of this framework or or why do you even think all that gold's been coming into the US is it just a tariff thing well it's a it's it's difficult to know I'm not an expert on the gold market or the gold exchanges So it's very difficult for me to judge But from what I understand uh one of the things that's upcoming from the summer is that under new BIS rules um gold bullion is a tier one asset And it means that the major banks can't hold derivatives as a tier one asset They've got to they've got to start uh using bullion And so there's a lot of cashing in of futures and derivatives uh towards bullion And the sizes that are going through the uh Comex exchange the settlement into gold bullion are eyewateringly large like figures that never never been seen before And then you run into the problem that for example the London gold market uh is supposed to be T+1 settlement and it's turned out to be T plus 6 weeks which is clearly something very very odd is going on there Um and you know you come out with banal excuses from the Bank of England They can't transport the bullion fast enough because of tra traffic logistics in London which is even more absurd but there we are Um so you know this is the situation you've got Now you know the other the other sort of segue into what's happening is then to say well okay the other interesting point which sort of links into gold is then to say well okay what's been happening to Bitcoin and maybe Bitcoin is a barometer of these liquidity and um and gold dynamics And there is a chart a little bit later on of that fact This by the way I I just want to say this is this is um an interesting head heads up before I get there This is uh data as of the end of February uh includes February I should say which looks at net inflows uh into the US dollar We do a lot of crossber flow analysis and this is what our data tells us So contrary to what the media have been banging the table about and saying there's this huge exodus out of US assets into the rest of the world uh and you know out of the dollar I mean there's no evidence for that okay for heaven's sake I mean okay there may have been some fund shifting but this is not a major shift out of the US dollar by any means on our definitions or our numbers money is still going into the US the reason the dollar is softening is not a secular uh phenomenon it's a cyclical response to a very strong US economy in Q4 and now a softer economy in Q1 relative to the rest of the world That's normally what you see You'd see the dollar going up in Q4 and coming down in Q1 That's exactly what's happened But anyway that's an aside Here is our weekly uh liquidity chart uh shown as the black line That's global liquidity weekly Uh this is shown as a six-w week change There's nothing uh you know there's no mystification in a six week change purely to remove the noise in the data series And I could have chosen four weeks or eight weeks but I chose six And what I've shown is the equivalent six week change in Bitcoin shown in orange And all I've done in the chart is to advance um the global liquidity series time series forward by 13 weeks uh to show that it's approximately uh sort of leading by about 3 months Now what this is basically saying is you could well get a rally in Bitcoin over coming months That's you know one accepts that because global liquidity is uh is picking up again Uh the problem that I'm trying to cite here is that I'm not looking at the next 3 months Generally my concerns are about the next 6 months 12 months 18 months and it may be that that black line starts to fall further and maybe faster uh over the horizon that I've got here So there may be a trading opportunity no question but this is what's happening Now the other thing to start to think about is that there is a distribution of uh of leads and lags with Bitcoin and global liquidity And this chart is trying to demonstrate two things These are statistical analyses One is a Granger causality test which is shown as black line And that basically tells us that when that line goes towards zero or is at zero there is strong granger of causality uh between uh global liquidity and uh the bitcoin price effectively from 7 weeks onwards and you can see that that thing So there's nothing or it's ambiguous up to that point but it seems to be clearer after that I just want to say this is such a great chart because you know as a statistics nurse as as well people get so caught up in correlation but what you have here is a causal factor and I think that's really important to say is that this is not spirious correlation this is a granger causality test that this is what impacts Bitcoin yeah the orange bars are basically showing the correlation coefficients at each particular uh weekly interval Now there is statistical noise in that So you got to sort of go slightly bossy and look at the uh uh the shape but you can see the sort of a humpshaped curve there which is probably peing at around 13 weeks which is why we get that result So that's that's the feature Now the thing that I wanted to focus on was actually this pie chart and what this pie chart is basically illustrating are the systematic influences on uh the price of bitcoin and this comes from u using a var vector auto regress uh regression model to try and under understand the systematic influences and what it shows is there are three basic sets of influences on bitcoin One is global liquidity The second is investor risk appetite Now the reason that's an important statement is that liquidity can be going up but risk appetite can be souring at the same time and in other words the S&P is dropping and consequently Bitcoin is getting a negative uh impact from that fall in risk appetite and that is something that influences Bitcoin but it doesn't influence gold Gold does not have that same response The other element that you can see in that pie chart are the two lower slices which is actually uh the gold price itself which has an influence on Bitcoin and uh the gold to bitcoin ratio Now um if you're a uh a statistician or a mathematician you can see that those two slices uh actually form uh what is uh what is called uh an error feedback process And what that basically is saying in in straightforward language is that Bitcoin and gold tend to move together over the long term but they don't move at the same speed Sometimes Bitcoin will go in advance of gold so gold then catches up and sometimes gold will move first and Bitcoin catches up So you get this sort of race or if you like of uh of of two creatures running a race One is in the lead and the other catches up and leads and then the other catches up So it's a bit like a horse race Uh and that's what's going on So if you look at what gold was doing in the fourth quarter it was subdued Bitcoin was racing ahead Now in the last quarter gold has really raced ahead and Bitcoin has really gone has done very little So that is a typical error feedback process But effectively what you could say is there are three influences on Bitcoin Gold risk appetite and global liquidity itself And our view generally is you've got to look at the steady state here uh in terms of long-term positioning And if you believe that debt is rising at this rate of 8% peranom then you've got to have monetary inflation hedges in your portfolio because for financial stability reasons liquidity has to rise at the same rate as debt And if liquidity rises uh Bitcoin and gold are going to rise at the same pace And if you want just simple proof of that since year 2000 the stock of the US government debt has increased by a whopping 9.6 times uh in total size the price of gold has gone up by 9.65 times just slightly more So gold has kept pace and it's all because of that relationship And Bitcoin's done even better as we know Fascinating I I love that analysis I think it's it's very preant and important Um okay Michael just to wrap us up here it sounds like when you when you just pair parse through the the outlook for liquidity shortterm as you shown that that short-term gauge there might be a bounce here for a little bit but for the most part things get pretty hairy in the fall Um and it sounds like it's just plain caution for 2025 Yeah there there is huge uncertainty until the Federal Reserve you know shows the color of its money so to speak Uh we've got uh the debt maturity wall coming up We've got a Federal Reserve that's seemingly selling on its hands are actually in practice still doing QT and the only central bank that's really easing liquidity aggressively is China But then look at the relative performance of the Chinese stock market versus Wall Street Uh that spells everything out Yeah absolutely Michael always great to have you on That was a really great hour Really enjoyed it Great Felix Enjoyed it enormously Thanks so much Thanks