"King of Liquidity" Dialogue: Global Liquidity Has Peaked and Is Declining, This Cycle Will Bottom Out in the Second Half of Next Year

Source: "What Bitcoin Did"

Compiled by: Felix, PANews

Michael Howell, founder of CrossBorder Capital and known as the "King of Liquidity," appeared on the show "What Bitcoin Did" to discuss the global liquidity cycle and its impact on assets such as Bitcoin and gold. Michael pointed out that the modern financial system is essentially a debt refinancing mechanism, and the fluctuations in liquidity directly govern the rise and fall of markets. He believes that the current growth in liquidity has peaked and is beginning to decline, which explains why liquidity-sensitive assets like Bitcoin are performing poorly. Although the market may face risks from tightening liquidity in the short term, holding assets that can withstand currency depreciation remains key to addressing systemic risks in the long run.

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

Michael: That's a good question. In short, money drives the market, it's that simple. Broadly speaking, the flow of funds, or the inflow of money into financial markets, initiates the entire cycle or investment cycle. The economy is downstream of the market, and geopolitics is downstream of the economy. This is our order of thinking. But what we really want to understand is whether there is money flowing into or out of the market, effectively changing transactions. One thing you need to think about or conceptualize is that there are roughly two large pools of funds in the world economy: one in the financial markets and the other existing almost independently in the real economy. Many people confuse the two, thinking they are the same, but they are not; they are entirely different. All existing funds must be somewhere, either in the financial sector or in the real economy. Generally speaking, as investors, we prefer funds to be in the financial or asset economy rather than in the real economy, because if funds are in the real economy, they are merely driving economic activity; whereas if they are in the financial or asset economy, they will push up asset prices, which is what we are really concerned about.

Host: You said, "the economy is downstream of the market," what does that mean? Many might think that what happens at the economic level is what drives the market, are you reversing that relationship?

Michael: It is indeed reversed. There is a feedback effect where the real economy can also affect the financial market in return. But the first stage is the creation of funds. Funds are first generated in the financial system, maintained through the financial system, and then spill over into the real economy; this is the main transmission mechanism. We often hear the saying that "the stock market can predict the trends of the real economy," but that is not prediction; it is more because the stock market reflects the surge or decrease of funds impacting the financial sector, which then produces a reverberation effect on the real economy. Traditional economics textbooks have it completely backward. Although I have a PhD in economics, much of what I learned about economics came from market practice; the academic view of the world is very distorted and not helpful. To understand the market, you only need to understand the flow of funds; many of the best investors are not economists; they rely on experience and common sense.

Host: How has your economic perspective changed? Have you shifted towards a more Austrian school viewpoint?

Michael: I don't know if it counts as an Austrian school viewpoint. I think both theories have flaws. Our starting point is that you must understand the process of fund creation in financial markets or the world economy. Funds are interchangeable; they tend to flow to where the highest returns or the most attractive investment and purchasing opportunities are. There is a trend in the money creation process, and there is also a very clear cycle. It is crucial to understand where we are in the cycle and what drives that cycle. Neither Keynesian economics nor Austrian economics explains the cycle well; they only explain the imbalance that occurs when the economy is in crisis and do not truly understand that what you most commonly see in the market is a fairly regular cycle.

The issue is understanding why these cycles occur and why policymakers react to certain events in that way. What we are seeing now is yet another example of the typical liquidity cycle in the market. This cycle began to explode in the latter half of 2022, and it may have peaked in terms of liquidity injection and is beginning to decline. However, there is still momentum in the system, asset prices are still rising, but the prices of liquidity-sensitive assets have encountered difficulties. Bitcoin is clearly a prominent example; it may be the most liquidity-sensitive asset on Earth. Then there is gold, which is also very sensitive to liquidity and is currently experiencing quite a difficult period. These are all characteristics of liquidity losing momentum.

Host: Macro strategist Luke Groman once called Bitcoin the "last effective smoke detector of liquidity." Before discussing where we are in the cycle, can you explain what drives these cycles? When liquidity rises and falls, where does the money go, and where does it come from?

Michael: The answer is actually quite complex, but I will try to explain it more directly: the main driving force is the central banks of various countries. While there are other factors, let’s assume it is the central banks for now. Central banks will begin to loosen policies. What prompts them to loosen policies? It could be external shocks (like the COVID-19 emergency) or financial crises; their response is essentially to intervene and inject liquidity into the market. The primary reason for doing this is not to revive economic activity; what they really want to do is save the financial system and the banks. Because ultimately, a financial crisis is essentially a debt refinancing crisis. We currently have too much debt. Economics textbooks are misleading; they often depict financial markets as mechanisms for raising new capital, where companies go to capital markets to raise new funds for new capital expenditures (like factories or equipment). This rarely happens in reality, except for the temporary surge that might be caused by the current AI boom; over the past 10 to 15 years, Western economies have not had that much capital expenditure. Most of the capital expenditure in the world economy is happening in China, and that is a state-led investment model. What are Western capital markets doing most of the time? They are refinancing existing debt and rolling over debt.

Given that we have accumulated a staggering $350 to $400 trillion in debt, with an average maturity of only about 5 years, this means you need to roll over $7 to $7.5 trillion of debt each year, which is an astonishing amount. To do this, you need the capacity of the financial sector and the ability of intermediaries to provide balance sheets. If this mechanism collapses, you will face a financial crisis. In a modern capitalist system dominated by credit money, you can never allow debt defaults because debt serves as collateral for new loans. Currently, about 70% to 80% of loans are based on collateral. You need some kind of asset to borrow against, and absurdly, this asset is often an old debt (like U.S. Treasuries). Therefore, you can never allow these debts to default; you must provide liquidity so that the debt refinancing process can continue. This is the fundamental response of central banks to all financial crises; supplementing liquidity is their ultimate responsibility. Although they verbally claim it is to control inflation or improve employment, the real goal is to ensure that debt refinancing can continue.

During the COVID-19 pandemic or the global financial crisis, funds pushed up asset markets. Liquidity is interchangeable; once it facilitates debt rollovers, it spills over into risk assets, corporate bonds, stocks, etc., thereby broadly pushing up asset markets. This is what we call a "bubble." Bitcoin and gold are excellent barometers for measuring this phenomenon; they are clearly favored during periods of abundant liquidity. Ultimately, liquidity will spill over into the real economy because the wealth effect will lead people to consume more, triggering further investment, and the real economy gains momentum. As the real economy gains momentum, it will require more liquidity, and thus it will begin to siphon liquidity from the financial sector. You will find a paradox: a strong real economy is rarely accompanied by a strong financial market, while a strong financial market is often associated with a weak real economy. Furthermore, if a strong economy leads to heightened inflation, central banks will initiate financial tightening, which will trigger larger cycles and lead to problems in debt refinancing, at which point they will have to intervene again to release liquidity, and the cycle will repeat itself.

Host: As we spiral into a debt spiral, with debt growing exponentially, will the peaks and troughs of these cycles become higher or lower, or have the cycles become shorter due to uncontrolled debt?

Michael: First of all, what we are seeing is that debt is growing exponentially because the debt-to-GDP ratio of most economies now exceeds 100%. Once interest payments reach a certain scale, debt will enter a vicious cycle of compound growth. For governments to curb debt growth, they must restore fiscal surpluses, but that is simply not possible. The welfare systems in the West need to be completely reformed, or it will lead to national bankruptcy. Because debt is growing exponentially, you need liquidity to grow exponentially as well, but liquidity tends to grow cyclically, which is why financial crises occur. However, whether financial crises will become larger and more frequent is not always the case. Not every subsequent crisis is larger, but their frequency is indeed quite stable. Our liquidity cycle has an average frequency of about 5 to 6 years. The reason is that the average maturity of debt in the world economy is also about 5 to 6 years, so essentially this is a debt refinancing cycle. By the way, this sharply contrasts with what people often refer to as the "4-year Bitcoin cycle." I do not believe Bitcoin has a 4-year cycle; I think it is this 5 to 6-year liquidity cycle that is dominating Bitcoin and gold. As for whether the next crisis will be larger than in 2008, I am not sure; it depends on the speed of policymakers' responses.

Host: Bitcoin peaked last October, coinciding with the peak of the liquidity cycle you mentioned. Where are we in the cycle now, and what will happen next?

Michael: The chart below shows the global liquidity cycle, with the black line representing the rate of change in liquidity through financial markets. The data we use dates back to 1965 and covers about 90 economies globally, observing about 30 different data series for each country. The sine wave above this black line was estimated using Fourier analysis in 2000 (25 years ago), and we have not changed it since. The U.S. Cycle Research Foundation requested our data for research last year, and they reached the same conclusion: the cycle is 65 months, which is quite standard. As you can see, this cycle peaked at the end of the third quarter last year, having bottomed out in September 2022. This upward trend in liquidity triggered a "bubble." The bad news is that this cycle may bottom out sometime in 2027 (possibly in the second half of 2027).

Another chart shows the six-week rate of change in global liquidity and its correlation with a basket of cryptocurrencies (60% Bitcoin, 30% Ethereum, 10% Solana). We have advanced the liquidity data by 13 weeks, and the correlation during this period exceeds 0.55. The latest data shows the lagging state of cryptocurrency prices, which is entirely consistent with the fact of slowing liquidity.

Host: Is gold's performance similar to this?

Michael: Yes, but there are different dynamics. Since purchasing cryptocurrencies is illegal in China, the People's Bank of China (PBOC), which drives liquidity, does not have a direct impact on cryptocurrencies. However, China has a significant influence on gold prices. The chart shows that changes in PBOC liquidity often affect gold trends about 2 to 2.5 months later. Gold has shown weakness in recent weeks.

Many believe that the "great devaluation trade" drove gold's rise over the past year, but we think the great devaluation has not truly occurred in the West. The West will have to monetize its exponentially exploding debt in the future, which will lead to massive inflation, but currently, only China is genuinely doing this. Due to capital controls in China, excess liquidity cannot easily flow out, and Chinese residents can only buy gold to hedge against inflation. The ban on purchasing cryptocurrencies in China is because it would become a shortcut for capital outflow. If you zoom in on the chart, you will find that almost at the same time as tensions began in Iran, China significantly reduced liquidity injections to slow down the economy and reduce oil imports. However, with the U.S.-Iran memorandum being torn up, China seems to have restarted liquidity injections. This may explain why the gold market could stabilize in the coming weeks if they continue to inject liquidity.

Host: When liquidity peaked and fell at the end of last year, Bitcoin experienced a crash. Will Bitcoin react violently to the liquidity decline? Will Bitcoin continue to drop or stabilize while waiting for liquidity to return?

Michael: Let's put it this way, if you are bullish on Bitcoin in the long term (we are too), you need to understand that cycles do not respect trends. Even if Bitcoin rises significantly in the coming years, its price may still be lower than it is now by the end of this year. This is the risk we need to understand. Besides the gold market and the China effect, the U.S. market is brewing significant problems. The two most important indicators in the world economy: oil prices and U.S. Treasury yields, have been suppressed to far below normal levels, which greatly drives economic growth. Strong economic growth may not be good for financial markets because funds are all in 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, indicating significant upward pressure. It's like holding a fully inflated beach ball underwater. The U.S. Treasury and the Federal Reserve are trying to suppress yields to lower interest expenses, and they are heavily intervening in the repurchase market. This brings two problems: first, when you suddenly let go, the ball will shoot up (just like when Japan ended yield curve control, the 10-year Treasury yield surged by 200 basis points, which is rare in the world). Second, if you squeeze one end of the balloon hard, the other end will bulge. They are squeezing the long-term market hard, and the short-term market (like the 2-year Treasury yield) will bulge, showing enormous pressure, indicating the private sector's real expectations for future interest rates.

Host: My friend Jeff Ross often says this proves that it is the market, not the Federal Reserve, that determines interest rates. Do you agree?

Michael: One hundred percent agree. It is always the long end of the market that determines the short end; the Federal Reserve can only exert influence for a very short time.

Host: Kevin Walsh is in a tricky situation right now; he was brought in to lower interest rates and establish an inflation working group, even suggesting he could accept 3% inflation. What will he do?

Michael: I don't think he can implement an easing policy because the U.S. economy has already grown very quickly. A few weeks ago, the annualized growth rate of M2 money supply soared to nearly 10%, and data from the Philadelphia Fed also showed a significant leap in activity and high inflation pressure, consistent with nominal GDP reaching 9%-10%. Trying to implement easing policy in this situation is simply madness. The strength of the dollar actually tells us they are moving towards a tighter direction. The negative spread between SOFR (Secured Overnight Financing Rate) and U.S. 2-year Treasury yields is also indicating that a tightening mechanism is imminent, just like in 2021-2022, when the last tightening led to a 25% drop in the S&P index and a 75% drop in Bitcoin.

Host: Do you think this is the reason Kevin Walsh wants to establish a special inflation working group? He claims to care more about the numbers to the left of the decimal point (i.e., allowing inflation to reach 3%). Is he manipulating the narrative?

Michael: He is clearly leaving himself some room for maneuver. The last time the Federal Reserve reached the 2% inflation target was about 63 or 64 months ago. They dare not admit that underlying inflation is actually much higher; otherwise, inflation expectations will become entrenched. But I believe that these little tricks policymakers are playing actually show that they know they must raise interest rates; they are just trying to prolong the process as much as possible. However, if they do not tighten soon, they will have to make more drastic corrections later.

Host: If they really "let go of the beach ball," how will the financial crisis unfold?

Michael: We measure crises using the "debt liquidity ratio." The core function of financial markets is to refinance debt. When this ratio is too high, financial markets lack sufficient liquidity to roll over debt, which triggers a crisis. All past financial crises have occurred when this ratio was extremely high. Conversely, if there is excess liquidity, it will lead to asset bubbles, which is what we just experienced as a "bubble." The way policymakers respond to crises is by injecting liquidity, which is why you should hold assets like Bitcoin and gold as inflation hedges for the long term as insurance. Additionally, during the COVID-19 pandemic, interest rates were lowered to zero or even negative, and many people rolled over their debt, leading to a massive debt maturity wall. From 2025 onwards, the amount of existing debt needing refinancing will continue to increase, not to mention new borrowing for defense spending. Once it derails, problems will arise in the repurchase collateral market, either the bond term premium will collapse, or credit spreads will widen, and funds will massively shift to safe assets. That is why I do not recommend aggressively buying now. Do not try to catch a falling knife; wait for the situation to stabilize. In the medium term, Bitcoin and gold will rebound strongly.

Host: So, will we face a financial crisis every six years?

Michael: It does seem to present this pattern. We said during the global financial crisis that the future world would be dominated by quantitative easing (QE). Do not just think about QE1; there will be a series of quantitative easing processes like QE2, QE3, QE4, etc., because central banks must regularly inject liquidity into the financial system, which cannot bear the enormous debt refinancing pressure. The idea that the Federal Reserve's balance sheet will significantly shrink is just a dream.

Host: How can they escape the debt predicament? Is inflation the only way?

Michael: They have no choice but to create inflation because they cannot allow the Treasury bonds used as collateral to default; otherwise, it would destroy the credit system. The great devaluation has not truly occurred in the West, while China is already doing it. Western governments may implement measures to keep funds domestic and prevent them from flowing into inflation-hedging tools. The West faces a future debt problem.

Host: Do you think they have a chance to escape debt through economic growth (like AI catalysis)?

Michael: There is no chance at all. Economic growth ultimately depends on population structures like young labor forces, and we do not have that condition now.

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

Michael: Yes, in addition, it is essential to pay attention to the jurisdiction of investments and diversify as much as possible. We must be realistic; the world has changed, and the West is bankrupt. For example, the reason the British Prime Minister changes every two years is fundamentally because there is no money to implement any agenda, which may also be the situation across Europe. In the face of leftist policies or government mandates requiring pension funds to buy bonds, gold and Bitcoin are clearly quality international assets that can be held.