Liquidity King: Global liquidity peaks; bottoms in the second half of next year within this cycle

Source:《What Bitcoin Did》; Compiled by: Felix, PANews

CrossBorder Capital founder, the “King of Liquidity” Michael Howell, appeared on the《What Bitcoin Did》program to discuss global liquidity cycles and their impact on assets such as Bitcoin and gold. Michael said that the modern financial system is essentially a debt refinancing mechanism, and that fluctuations in liquidity directly dominate the rise and fall of markets. He believes that current liquidity growth has already peaked and is starting to retreat, which explains why liquidity-sensitive assets like Bitcoin have performed poorly. Although in the short term the market may face risks brought on 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 for you in the economy?

Michael: It’s a great question. In short, money drives markets—that’s basically it. Broadly speaking, what kicks off an entire cycle or investment cycle is the movement of capital—capital inflows into financial markets. The economy is downstream of the market, and geopolitics is downstream of the economy. That’s the way we think. But what we really want to understand is whether capital is flowing into or out of the market, thereby effectively changing trading conditions. One thing you need to think about or conceptualize is that there are roughly two major pools of capital in the world economy: one in financial markets and the other existing almost independently in the real economy. Many people confuse these two and think they’re the same thing, but they’re not—they are fundamentally different. All capital must exist somewhere: either in the financial sector or in the real economy. Generally, as investors, we prefer capital to be in the financial or asset economy rather than the real economy, because if capital is in the real economy, it only supports economic activity; whereas if it’s in the financial or asset economy, it pushes up asset prices—that’s what we truly care about.

Host: You said “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 factors—you’re kind of reversing that relationship, right?

Michael: Yes, it’s the other way around. There are feedback effects here, and the real economy can also influence financial markets in return. But the first stage is the creation of capital. Capital originates in the financial system first, sustains itself through the financial system, and then spills over into the real economy—that’s the main transmission mechanism. We often hear the claim that “the stock market can predict the real economy’s trajectory,” but that isn’t prediction. It’s more because the stock market reflects the surge or decline of capital in the financial sector after shocks, and then produces an echo effect on the real economy. Traditional economics textbooks have it completely backwards. I have a PhD in economics, but much of what I learned came from market practice. Academia’s view of the world is distorted and not very helpful. To understand markets, you just 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 views change? Did you shift toward the Austrian School?

Michael: I don’t know if you can call it the Austrian School. I think both frameworks have flaws. Our starting point is that you must understand the process of capital creation in financial markets or the world economy. Capital is interchangeable, and it tends to flow to where returns are highest or where the most attractive investment and buying opportunities exist. The process of money creation has a tendency, and it also has a very clear cycle. It’s important to know where we are in the cycle and what drives it. Whether it’s Keynesian economics or Austrian School economics, neither does a good job of explaining cycles. They only describe the imbalances when a crisis happens in the economy, but they haven’t truly understood that what you most commonly see in markets is a fairly regular cycle.

The question is why these cycles occur and why policymakers respond to certain events the way they do. What we’re seeing now is another typical example of a liquidity cycle in the market. This cycle began to break out in the mid-to-late 2022, and it may already have peaked in terms of liquidity injection and started to decline. But there’s still momentum in the system—asset prices are still rising—yet asset prices that are most sensitive to liquidity are already struggling. Bitcoin is obviously a clear example; it may be the most liquidity-sensitive asset on Earth. Then there’s gold—it’s also very sensitive to liquidity, and it’s currently in a similarly difficult phase. These are all characteristics of liquidity losing momentum.

Host: Macro strategist Luke Groman once described Bitcoin as a “smoke alarm for liquidity, the last effective one.” Before talking about where we are in the cycle, can you explain what drives these cycles? When liquidity surges and recedes, where does the money go, and where does it come from?

Michael: The answer is actually complicated, but I’ll try to explain it in a more direct way: the main driver is central banks. There are other factors, but for now let’s assume it’s central banks. Central banks start easing policy. What prompts them to ease? It could be external shocks (like emergencies during the COVID-19 pandemic), or it could be financial crises—whatever the case, their response is basically to intervene and inject liquidity into the market. The primary reason for doing this isn’t to revive economic activity; what they really want is to save the financial system and the banks. Because in the end, financial crises are essentially debt refinancing crises. We simply have too much debt right now. Economics textbooks are misleading; they often portray financial markets as mechanisms for raising new capital—companies go to capital markets to raise new funding to invest in new capital expenditures (like plants or equipment). In reality this rarely happens, except for the temporary surge that the AI boom might be causing. Over the past 10 to 15 years, Western economies haven’t had nearly that many capital expenditures. Most of the world’s capital expenditures have been carried out in China, and that’s a state-led investment model. So what are Western capital markets doing most of the time? They’re refinancing existing debt and rolling over maturing debt.

Given that we’ve piled up $350 to $400 trillion in debt, with an average maturity of only about 5 years, that means you have to roll over $70 to $75 trillion of debt every year—that’s an astonishing figure. To do this, 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 must not allow debt defaults, because debt is collateral used to support new loans. Today, 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 (such as U.S. Treasury bonds). So you must not allow those debts to default; you have to provide liquidity so the debt refinancing process can continue. This is the central bank’s basic response to every financial crisis—their ultimate job is to add liquidity. Although they say out loud that it’s to control inflation or improve employment, the fundamental objective is to ensure debt refinancing can keep going.

During the COVID-19 period or the global financial crisis, capital pushed up asset markets. Liquidity is interchangeable; once it facilitates debt rollovers, it overflows into risk assets, corporate bonds, stocks, and so on, starting a broad-based push higher in asset markets. That’s what we call a “bubble.” Bitcoin and gold are good barometers for this phenomenon; they are clearly chased during times of abundant liquidity. Eventually, liquidity overflows into the real economy too, because the wealth effect makes people consume more, which leads to further investment, giving the real economy momentum. As the real economy gains momentum, it needs more liquidity, and then it starts pulling liquidity out of the financial sector. You end up with a paradox: strong real economic performance rarely comes with strong financial markets, while strong financial markets are often associated with a weak real economy. Also, if strong growth leads to worse inflation, the central bank will start tightening financial conditions, which creates a bigger cycle and causes problems for debt refinancing—then they have to step back in again to release liquidity. The cycle repeats.

Host: As we fall into a debt spiral, debt grows exponentially. Do the peaks and troughs of these cycles become higher or lower, or do cycles get shorter because debt gets out of control?

Michael: First, what we see is debt growing exponentially, because the debt-to-GDP ratio in most economies is now above 100%. Once interest payments become large enough, debt will compound in a vicious cycle. For governments to curb debt growth, they would need to restore fiscal surpluses, but that’s basically impossible. Western welfare systems need to be completely reformed, otherwise they will lead to countries going bankrupt. Since debt is growing exponentially, you also need liquidity to grow exponentially, but liquidity growth is typically cyclical—which is why financial crises happen. If financial crises are getting larger and more frequent, that isn’t always true. Not every subsequent crisis is bigger, but the 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 in the world economy is also about 5 to 6 years—so in essence, this is a debt refinancing cycle. By the way, this is in sharp contrast to the “Bitcoin 4-year cycle” people often talk about. I don’t believe Bitcoin has a 4-year cycle; I think the 5- to 6-year liquidity cycle dominates Bitcoin and gold. As for whether the next crisis won’t be larger than 2008, I’m not sure—that depends on how quickly policymakers respond.

Host: In October last year, Bitcoin topped out, which lined up exactly with the liquidity cycle topping out you described. Where are we in the cycle now, and what happens next?

Michael: The figure below shows the global liquidity cycle. The black line represents the rate of change in liquidity through financial markets. Our data go back to 1965, covering about 90 economies worldwide, with each country observing around 30 different data series. Above this black line is a sine wave that was estimated using a Fourier analysis in 2000—that is, 25 years ago—and since then we haven’t changed it. Last year, the U.S. Federal Reserve Bank? No—the U.S. Institute for Cycle Research asked for our data to conduct research, and they reached the same conclusion: the cycle is 65 months, which is pretty standard. As you can see, the cycle peaked at the end of Q3 last year; before that, it bottomed in September 2022. This upward trend in liquidity triggers “bubbles.” The bad news is that this cycle may bottom at some point in 2027—possibly in the second half of 2027.

Another chart shows the relationship between the six-week rate of change in global liquidity and a crypto basket (60% Bitcoin, 30% Ethereum, 10% Solana). We advanced the liquidity data by 13 weeks, and during that time span the correlation has been above 0.55. The latest data show a lag in crypto prices, which lines up perfectly with the fact that liquidity has slowed.

Host: Is gold’s performance similar to this?

Michael: Yes, but with different dynamics. Because it’s illegal to buy crypto in China, the driving force behind liquidity—the People’s Bank of China (PBOC)—doesn’t have a direct impact on crypto. But China has a huge impact on gold prices. The chart shows that changes in PBOC liquidity tend to affect gold’s price movement about 2 to 2.5 months later. In recent weeks, gold has weakened.

Many people think that the “big debasement trade” drove gold’s gains over the past year, but we believe large-scale debasement hasn’t truly happened in the West yet. The West will eventually have to monetize its exponentially exploding debt currency, which will bring large-scale inflation—but for now, only China is doing it. Because China has capital controls, excess liquidity can’t easily flow out, so Chinese residents can only buy gold as a hedge against inflation. China bans crypto purchases because it would become a shortcut for capital outflows. If you zoom in on the chart, you’ll find that around the time tensions in Iran began, China sharply reduced liquidity injections to slow the economy and reduce oil imports. But after the U.S.-Iran memorandum of understanding was torn up, China seems to have restarted liquidity injections. This may explain why, if they continue injecting liquidity, the gold market could stabilize in the coming weeks.

Host: When liquidity peaked and fell at the end of last year, Bitcoin saw a crash. Will Bitcoin react sharply to the decline in liquidity versus compared liquidity? Will Bitcoin keep falling next, or will it stabilize and wait for liquidity to return?

Michael: Let me put it this way: if you’re bullish on Bitcoin long term (we are also bullish), you have to understand that the cycle does not respect trends. Even if Bitcoin rises dramatically over the next few years, by the end of this year its price might still be lower than it is now. That’s the risk we need to understand. Besides the gold market and the China effect, the U.S. market is brewing a major problem. The two most important indicators in the world economy—oil prices and U.S. Treasury yields—have been pushed down to far below normal levels, which is massively boosting economic growth. Strong economic growth may not be good news for financial markets, because the money is in the real economy. The chart shows the correlation between U.S. nominal GDP growth and the risk-adjusted yield on the U.S. 10-year Treasury. Right now, U.S. Treasury yields are far below what they should be, and there is significant upside pressure. It’s like pressing down an inflated beach ball underwater. The U.S. Treasury and the Fed are working hard to suppress yields in order to lower interest expense, and for that they are intervening heavily in the repo market. This creates two problems: first, when you suddenly let go, the ball will shoot upward hard (as happened when Japan ended yield curve control—the 10-year Treasury yield surged by 200 basis points, which is a rare event globally). Second, if you squeeze the end of the airballoon, the other end bulges. They are squeezing in the long-term markets, and in the short-term markets (like the 2-year Treasury yield) it bulges, showing huge stress. That signals 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 think the same?

Michael: Absolutely agree. The long end of the market determines the short end, and the Fed can only influence in a very short window.

Host: Then what’s happening with Kevin Warsh right now seems tricky. He was brought in to cut rates and to set up an inflation working group, and he even said he could accept inflation of 3%—what exactly will he do?

Michael: I don’t think he can implement easing policy, because the U.S. economy is already growing extremely fast. A few weeks ago, the annualized growth rate of M2 briefly surged to nearly 10%, and data from the Federal Reserve Bank of Philadelphia also show activity jumped sharply and there’s high inflation pressure—this lines up with nominal GDP reaching 9% to 10%. In this situation, trying to ease is crazy. The strength of the dollar is actually telling us they’re moving toward tighter conditions. The SOFR rate (PANews note: secured overnight financing rate, an indicator used to calculate overnight borrowing costs using U.S. Treasuries as collateral) versus the U.S. 2-year Treasury yield also shows a negative spread, just like in 2021-2022. This signals that a tightening mechanism is coming. The last time tightening happened, the S&P 500 fell 25% and Bitcoin fell 75%.

Host: Do you think this is why Kevin Warsh said he’s setting up a special inflation working group—because he cares more about the numbers left of the decimal point (i.e., allowing inflation to reach 3%)? Is he shaping the narrative operationally?

Michael: He’s clearly giving himself room to maneuver. The last time the Fed reached a 2% inflation target was about 63 or 64 months ago. They can’t admit that underlying inflation is actually much higher, otherwise inflation expectations will become fixed. But I think these small tricks by policymakers actually show they know they must raise rates—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.

Host: If they really “unleash the beach ball,” how would the financial crisis specifically evolve?

Michael: We use the “debt liquidity ratio” to measure the crisis. The core role of financial markets is to facilitate debt refinancing. When this ratio gets too high, financial markets lack enough liquidity to roll over debt, which triggers a crisis. All past financial crises happened when this ratio was extremely high. Conversely, if liquidity is excessive, it leads to asset bubbles—that’s the “bubble” we just went through. Policymakers’ response to a crisis is to inject liquidity, which is why you should hold inflation-hedging assets like Bitcoin and gold as insurance over the long term. Also, during the COVID-19 period, interest rates were cut to zero and even negative, and many people refinanced debt, which created a huge wall of debt maturities. Starting in 2025, the amount of existing debt that needs refinancing will keep increasing—this is not even counting new borrowing such as defense spending. Once things derail, repo collateral markets will run into problems: either bond term premia collapse, or credit spreads widen, and funds will shift massively into safe assets. That’s why I don’t recommend aggressively buying right now. Don’t try to catch a falling knife; once the situation stabilizes, in the medium term Bitcoin and gold should rebound strongly.

Host: So are we going to get a financial crisis every six years?

Michael: It does seem to follow that pattern. During global financial crises, we said the future world would be dominated by Quantitative Easing (QE). Don’t just think about QE1—there will be a sequence of QE rounds, like QE2, QE3, QE4, and so on, because central banks today have to inject liquidity back into the financial system on a regular basis; the system itself can’t withstand the enormous pressure of debt refinancing. The idea that the Fed’s balance sheet will shrink significantly is wishful thinking.

Host: How will they get out of the debt trouble? Only through inflation?

Michael: They have no choice but to create inflation, because they can’t let the government bonds—used as collateral—default, otherwise it would destroy the credit system. Large debasement in the West hasn’t really happened yet, but China is already doing it. Western governments might introduce measures to keep funds trapped domestically so they don’t flow into inflation-hedging tools. The West also faces a future debt problem.

Host: Do you think they have a chance to escape debt problems through economic growth, like AI as a catalyst?

Michael: No chance at all. Economic growth ultimately depends on demographics like younger labor forces, and we don’t have that condition now.

Host: What actionable advice do you have for listeners? Still buy gold and Bitcoin?

Michael: Yes, and you also must pay attention to the jurisdiction where you invest, and achieve diversification as much as possible. We have to be realistic: the world has changed, and the West has already gone bankrupt. For example, the reason the UK Prime Minister changes every two years is basically that they don’t have money to implement any agenda—this may be the situation across all of Europe too. In the face of left-wing policies or the government forcing pension funds to buy bonds, gold and Bitcoin are clearly high-quality international assets that can be held.