“Liquidity King” dialogue: Global liquidity has peaked and started to decline; the bottom of this cycle will be reached in the second half of next year

Source: 《What Bitcoin Did》

Curated by: Felix, PANews

CrossBorder Capital founder and the “King of Liquidity” Michael Howell joins the 《What Bitcoin Did》 program to discuss the global liquidity cycle and its impact on assets such as Bitcoin and gold. Michael points out that the modern financial system is essentially a debt refinancing mechanism, and that fluctuations in liquidity directly determine the rise and fall of markets. He believes that current liquidity growth has already peaked and begun to decline, which helps explain why liquidity-sensitive assets such as Bitcoin have been performing weakly. Although in the short term the market may face risks caused by tighter liquidity, in the long run, holding assets that can withstand currency debasement remains key to addressing systemic risk.

Host: Why are you so focused on liquidity? What does liquidity mean to you in the economy?

Michael: That’s a good question. Simply put, money drives markets—that’s really all there is to it. In broad terms, what kicks off an entire cycle or investment cycle is the flow of capital, that is, capital flowing into financial markets. The economy is downstream of the market, and geopolitics is downstream of the economy. That’s the order of our thinking. But what we truly want to understand is whether capital is flowing into or out of markets, thereby effectively changing transactions. One thing you need to think about, or conceptualize, is that in the world economy there are roughly two major pools of capital: one exists in financial markets, and the other exists almost independently in the real economy. Many people confuse the two, assuming they are the same, but they are not—they are completely different. All capital must exist somewhere—either in the financial sector or in the real economy. In general, as investors, we prefer capital to be in financial or asset economics rather than in the real economy, because if capital is in the real economy, it only pushes economic activity; but if it’s in financial or asset economics, it pushes up asset prices—that’s what we really care about.

Host: When you say “the economy is downstream of the market,” what does that mean? Many people might think that what happens at the economic level is what drives the market. Aren’t you reversing that relationship?

Michael: Yes, it’s the other way around. There’s a feedback effect here, and the real economy can also affect financial markets in return. But the first stage is the creation of money. Money originates in the financial system, is maintained through the financial system, and then spills over into the real economy—that’s the main transmission mechanism. We often hear the saying that “the stock market can predict the direction of the real economy,” but it’s not prediction. It’s more that the stock market reflects a surge or decline in capital entering the financial sector due to shocks, and then produces an echo effect on the real economy. Traditional economics textbooks have completely gotten this backward. I have a PhD in economics, but much of what I learned came from market practice, and academic perspectives on the world are highly distorted and not helpful at all. To understand markets, you only need to understand capital flows. Many of the best investors aren’t economists; they rely on experience and common sense.

Host: So how did your economic viewpoint change? Did you shift toward the Austrian School?

Michael: I don’t know whether you could call it Austrian School thinking. I think both sets of theories have flaws. Our starting point is that you must understand the process by which money is created in financial markets or in the world economy. Money is substitutable, and it tends to flow to where returns are highest or where there are the most attractive investment and purchase opportunities. There’s a trend in the money creation process, and there is also a very clear cycle. It’s important to understand where we are in that cycle and what drives it. Whether it’s Keynesian economics or Austrian economics, neither framework explains cycles very well. They only explain the disequilibrium state when crises occur in the economy, but they don’t truly understand that what you most commonly see in markets are cycles that are fairly regular.

The problem is understanding why these cycles occur in the first place, and why policymakers respond to certain events in the way they do. What we’re seeing now is another example of a typical liquidity cycle in markets. This cycle began to break out in the latter half of 2022. It may already have peaked in terms of liquidity injection and started to roll over. But there’s still momentum in the system: asset prices are still rising, yet the asset prices most sensitive to liquidity have encountered difficulties. Bitcoin is obviously a clear example—it may be the most liquidity-sensitive asset on Earth. Then there’s gold, which is also very sensitive to liquidity and is currently going through a similarly difficult period. These are all signs that liquidity is losing momentum.

Host: Macro strategist Luke Groman once called Bitcoin the “last effective smoke alarm for liquidity.” Before we talk about where we are in the cycle right now, can you explain what drives these cycles? When liquidity ebbs and flows, where does the money go, and where does it come from?

Michael: The answer is actually quite complicated, but I’ll try to explain it more directly: the main driver is the central banks of various countries. Although there are other factors, for now let’s assume it’s the central banks. Central banks start easing policy. What would prompt them to ease? It could be an external shock—such as the emergency during the COVID-19 pandemic—or it could be a financial crisis. Their response is basically to step in and inject liquidity into the market. The primary reason they do this is not to revive economic activity; what they truly want to do is to rescue the financial system and the banks. Because at the end of the day, financial crises are essentially debt refinancing crises. We currently have far too much debt. Economics textbooks are misleading: they often portray financial markets as mechanisms for raising new capital, where companies go to capital markets to raise new funds to invest in new capital expenditures (such as factories or equipment). In reality, this rarely happens, except perhaps for a temporary surge caused by the current AI boom. Over the past 10 to 15 years, Western economies haven’t had that many capital expenditures. Most capital expenditures in the world economy have been carried out in China, and that is a state-led investment model. So what are Western capital markets doing most of the time? They are refinancing existing debt and rolling over maturing debt.

Given that we have accumulated 350 to 400 trillion in debt, with an average maturity of only about 5 years, this means you have to roll over 70 to 75 trillion of debt every year—that’s an astonishing amount. To do that, you need the capacity of the financial sector and the ability of intermediaries to provide balance sheets. If this mechanism breaks down, you face a financial crisis. In a modern capitalist system dominated by credit money, you absolutely cannot allow debt defaults, because debt is the collateral used to support new lending. Now about 70% to 80% of loans are based on collateral. You need some asset to borrow against, and absurdly, that asset is often an old debt instrument (such as U.S. Treasuries). Therefore, you cannot allow these debts to default—you must provide liquidity so that the debt refinancing process can continue. This is the central bank’s basic response to every financial crisis: replenishing liquidity is their ultimate responsibility. Even though they say it’s to control inflation or improve employment, the real goal is to ensure that debt refinancing can keep going.

During the COVID-19 period or a global financial crisis, money pushes up asset markets. Liquidity is substitutable. Once it supports debt rollover, it spills over into risk assets—such as corporate bonds and stocks—and then broadly lifts asset markets. That’s what we call a “bubble.” Bitcoin and gold are excellent barometers for this phenomenon: when liquidity is abundant, they are clearly in demand. Ultimately, liquidity will spill over into the real economy, because the wealth effect causes people to consume more, which triggers further investment, giving the real economy momentum. As the real economy gains momentum, it needs more liquidity, so it starts pulling liquidity away from the financial sector. You’ll find a paradox: a strong real economy rarely comes with a strong financial market, while a strong financial market is often associated with a weak real economy. Moreover, if inflation worsens due to strong economic performance, central banks initiate financial tightening, which creates a larger cycle and causes problems for debt refinancing. Then they have no choice but to step back in again to release liquidity, and the cycle repeats endlessly.

Host: As we get trapped in a debt spiral and debt grows exponentially, do the peaks and troughs of these cycles become higher or lower, or do the cycles become shorter because debt runs out of control?

Michael: First, what we’re seeing is exponential debt growth, because the debt-to-GDP ratios in most economies are now above 100%. Once interest payments become large enough, debt starts compounding in a vicious cycle. To curb debt growth, governments would need to restore fiscal surpluses, but that simply can’t happen. Western welfare systems require radical reform, otherwise countries will go bankrupt. Because debt is growing exponentially, you also need liquidity to grow exponentially, but liquidity often grows cyclically—this is why financial crises occur. But if you say that financial crises are getting bigger and more frequent, that isn’t always true. Not every subsequent crisis is larger, but their frequency is fairly stable. The average frequency of our liquidity cycles is about 5 to 6 years. The reason is that the average debt maturity period worldwide is also about 5 to 6 years, so fundamentally this is a debt refinancing cycle. By the way, this contrasts sharply with the commonly discussed “Bitcoin 4-year cycle.” I don’t believe Bitcoin has a 4-year cycle. I think it’s this 5 to 6-year liquidity cycle that dominates Bitcoin and gold. As for whether the next crisis won’t be bigger than 2008, I’m not sure—it depends on how quickly policymakers respond.

Host: Last October, Bitcoin topped out, which perfectly matches the liquidity cycle topping out as you described. Where are we in the cycle now, and what happens next?

Michael: The chart below shows the global liquidity cycle. The black line represents the rate of change of liquidity through financial markets. The data we use can be traced back to 1965, covering about 90 economies globally. For each country, we observe around 30 different data series. Above this black line is a sine wave estimated through Fourier analysis in 2000—25 years ago—and we haven’t changed it since. Last year, the U.S.-based Economic Research Foundation requested our data for research, and they reached the same conclusion: the cycle is 65 months, which is fairly standard. As you can see, this cycle peaked at the end of the third quarter last year. Before that, it bottomed out in September 2022. This rising trend in liquidity triggered “bubbles.” The bad news is that this cycle may bottom out at some point in 2027—possibly in the second half of 2027.

Another chart shows the correlation between the global liquidity 6-week rate of change and a crypto basket (60% Bitcoin, 30% Ethereum, 10% Solana). We advanced the liquidity data by 13 weeks, and during that period the correlation was above 0.55. The latest data shows a lag in crypto prices, which is fully consistent with the fact that liquidity has slowed.

Host: Is gold’s performance similar to this?

Michael: Yes, but with different dynamics. Because buying crypto in China is illegal, the People’s Bank of China (PBOC), which drives liquidity, does not have a direct impact on crypto. But China has a huge influence on gold prices. The chart shows that changes in PBOC liquidity tend to affect gold’s price trend about 2 to 2.5 months later. In recent weeks, gold has been weakening.

Many people believe that the “great devaluation trade” drove gold’s rise over the past year, but we think the great devaluation hasn’t truly happened in the West yet. The West in the future must monetize its exponentially exploding debt currency. That will bring massive inflation, but so far only China has actually done it. Because China has capital controls, excess liquidity cannot easily flow out, so Chinese residents can only buy gold to hedge inflation. China bans buying crypto because it would become a shortcut for capital outflows. If you zoom in on the chart, you’ll find that almost as the tensions in Iran began, China significantly reduced liquidity injections to slow the economy and reduce oil imports. But after the U.S.-Iran memorandum of understanding was torn up, China appears to have restarted liquidity injections. This may explain why the gold market could stabilize in the coming weeks if they continue injecting liquidity.

Host: When liquidity peaked and started to decline at the end of last year, Bitcoin saw a sharp drop. Will Bitcoin react dramatically to the decline in liquidity relative to Bitcoin? Will Bitcoin keep falling, or will it stabilize and wait for liquidity to return?

Michael: Let’s put it this way: if you’re bullish on Bitcoin long term (we are also bullish), you need to understand that the cycle doesn’t respect the trend. Even if Bitcoin surges significantly over the next few years, by the end of this year its price could still be lower than it is now. That’s the risk we need to understand. Apart from the gold market and the China effect, the U.S. market is brewing major problems. The two most important indicators in the world economy—oil prices and U.S. Treasury yields—have both been pushed far below normal levels, which has strongly boosted economic growth. Strong economic growth isn’t necessarily good for financial markets, because all the money is going into the real economy. The chart shows the correlation between U.S. nominal GDP growth and risk-adjusted U.S. 10-year Treasury yields. Currently, U.S. Treasury yields are far below where they should be, leaving substantial upward pressure. It’s like holding an inflated sandball under water. The U.S. Treasury and the Fed are working extremely hard to suppress yields in order to keep interest expense down, and for that they are intervening heavily in the repo market. This creates two problems: first, when you suddenly let go, the ball will surge upward sharply (just like what happened when Japan ended yield curve control—U.S. 10-year Treasury yields jumped by 200 basis points, which is rare globally). Second, if you squeeze the balloon from one end tightly, the other end will bulge. They are squeezing the long-term market, and in the short-term market (such as U.S. 2-year Treasury yields) it bulges, showing huge pressure—indicating the private sector’s true expectations for future interest rates.

Host: My friend Jeff Ross often says this proves that it’s the market, not the Fed, that determines interest rates. Do you see it the same way?

Michael: A hundred percent. It’s always the market’s long end that determines the short end, and the Fed can only influence it over an extremely short time frame.

Host: Then Kevin Warsh’s situation is quite tricky right now. He was brought in to lower rates and to set up an inflation working group, and he even said he can accept 3% inflation. What exactly will he do?

Michael: I don’t think he can implement easing, because the U.S. economy is already growing extremely fast. A few weeks ago, the annualized growth rate of M2 once surged to nearly 10%, and data from the Philadelphia Fed also shows activity jumping sharply and strong inflationary pressure, which is consistent with nominal GDP reaching 9%-10%. In such a situation, trying to ease policy is crazy. The strength of the dollar actually tells us that they’re moving toward further tightening. The negative spread between SOFR (PANews note: secured overnight financing rate, a benchmark for overnight borrowing costs calculated using U.S. Treasuries as collateral) and U.S. 2-year Treasury yields is also like 2021-2022, signaling that a tightening mechanism is about to come. The last time tightening happened, the S&P 500 fell 25% and Bitcoin fell 75%.

Host: Do you think this is why Kevin Warsh wants to set up a special inflation working group? He said he cares more about the number on the left side of the decimal point (meaning allowing inflation to reach 3%). Is he trying to shape the narrative operationally?

Michael: He’s clearly giving himself room to maneuver. The last time the Fed hit its 2% inflation target was about 63 or 64 months ago. They don’t dare to admit that underlying inflation is actually much higher, otherwise inflation expectations would get locked in. But I think these little tricks by policymakers actually show that they know they have to raise rates, and they’re just trying to extend the process as long as possible. But if they don’t tighten early, later they’ll have to overcorrect more.

Host: If they really “let go of the sand volleyball,” how would a financial crisis play out specifically?

Michael: We use the “debt liquidity ratio” to measure the crisis. The core role of financial markets is to provide debt refinancing. When this ratio becomes too high, financial markets lack sufficient liquidity to roll over debt, and that triggers a crisis. Every financial crisis in the past occurred when this ratio was extremely high. Conversely, if there is an overabundance of liquidity, it triggers asset bubbles—that is the “bubble” we just experienced. Policymakers’ way of responding to a crisis is to inject liquidity, which is why you should hold long-term currency-inflation hedge assets such as Bitcoin and gold as insurance. Also, during the COVID-19 period, interest rates were cut to zero or even negative, and many people refinanced their debts, leading to a huge debt maturity wall. Starting in 2025, the amount of existing debt that needs refinancing will keep increasing—this doesn’t even include new borrowing such as defense spending. Once everything derails, problems will appear in the repo collateral market: either bond term premia collapse, or credit spreads widen, and then funds will shift massively to safe assets. That’s why I don’t recommend aggressively buying right now. Don’t try to catch a falling knife. Wait until the situation stabilizes, and in the medium term Bitcoin and gold should rebound strongly.

Host: So does that mean we’ll get a financial crisis every six years?

Michael: It certainly shows that pattern. During past global financial crises, we’ve said that the future world will be dominated by Quantitative Easing (QE). Don’t just think of QE1—there will be QE2, QE3, QE4, and a whole series of QEs, because central banks now must regularly inject liquidity back into the financial system, and the system itself cannot withstand the massive pressure from debt refinancing. The idea that the Fed’s balance sheet will shrink significantly is just a dream.

Host: How do they get out of the debt trouble? Is it only through inflation?

Michael: They have no choice but to create inflation, because they can’t allow default on Treasury bonds that serve as collateral—that would destroy the credit system. The great devaluation hasn’t truly happened in the West yet, but China is already doing it. Western governments may introduce measures to keep funds trapped domestically and prevent them from flowing into currency-inflation hedging tools. The West is facing an even bigger future debt problem.

Host: Do you think they have a chance to escape debt through economic growth—such as AI catalysts?

Michael: There is no chance. Economic growth ultimately depends on population structures like a young workforce, and we don’t have that condition now.

Host: What actionable advice do you have for listeners? Is it still buy gold and Bitcoin?

Michael: Yes. Also, you must pay attention to the jurisdiction where you invest and diversify as much as possible. We have to be realistic: the world has changed, and the West has gone bankrupt. For example, the reason the UK prime minister changes every two years is fundamentally that there’s no money to implement any agenda. That might be the situation across all of Europe as well. In a context of left-wing policies or the government forcibly requiring pension funds to buy bonds, gold and Bitcoin are clearly high-quality international assets that can be held.

Further reading: Macro master Raoul Pal interviews a Wall Street strategist: computing power, energy, and Agent economics