Catch up on 8 Takeaways from Michael Howell

An inflation bogeyman that won't go away, the "troubling" bond market, the incoming refinancing crisis, and why a hangover is inevitable

“If I was advising incoming President Trump, I'd say what you want to do now is create a recession as soon as you can to try and get people back into the fixed income markets. Well, good luck with that.” - Michael Howell

ICYMI last Sunday… CrossBorder Capital managing director

Michael Howell

joined me for a special interview on the liquidity landscape, the US debt problem, and why inflation remains a major threat. Here’s what we learned:

Capital Markets Ain’t About Financing Capital Spending Anymore

Pick up a finance textbook and it says capital markets are all about interest rates and financing new capital spending. “Unfortunately, they’re not anymore,” Michael said. “What they really are, are massive debt refinancing vehicles - something like 3 out of every 4 transactions going through world financial markets now are effectively a debt rollover of some form.”

Enormous waves of debt needs refinancing every year, and that needs liquidity. Don’t get the liquidity? That’s when you get refinancing crises. “And that’s basically what we can see littered over the past 2 decades, with crashes and the GFC or whatever it may be.”

“We’re All Debt Junkies”

The enormous waves of debt that need servicing aren’t getting any smaller. “We’re all debt junkies, governments in particular,” Michael said. “But it's not just governments, it's the whole of the private sector globally. $350 trillion of debt is basically the bill for all debt, private and public.” Worryingly, there is very strong debt growth because of aging populations, greater defense spending, social security, etc. “And what do governments do? They just basically kick the can down the road and the interest bill is simply added to the debt pile,” he added.

The Debt/Liquidity Relationship is Changing

Michael says that the pile of debt stands in a reasonably constant relationship with the pool of liquidity. “If that comes out of equilibrium, so there's a lot more debt relative to liquidity, then you tend to get refinancing crises. If there's a lot of liquidity relative to debt, you tend to get asset market booms,” he said.

For much of the last 4-5 years, Michael says there has been too much liquidity relative to the debt - but that’s now changing. There is increasing demands on the liquidity pool, firstly because a lot of debt that was refinanced during the zero/low interest rate Covid times will start rolling over next year and into the late 2020s.

The second big issue soaking up the liquidity pool is…

Inflation: Still a problem

“If inflation starts to pick up, even a percent or two percentage points of core inflation, that is going to start to absorb liquidity from the system because the real economy will start to demand more cash or more credit,” Michael said.

“I still think inflation is the major bogey to jump next year,” he added. “And it's not that we're seeing 9%, 10 % inflation rates. We're seeing nagging inflation, which is excoriating the market slowly.”

The Fed is Engaging in “Not-QE QE”

Michael says the Fed has been operating a “not-QE QE” regime. “They’re kind of denying that they’re doing QE, but if you look at what’s happening to bank reserves or what’s happening in terms of Fed liquidity, that’s clearly been on an upward course. That’s why markets generally have been pretty firm.”

And Michael says that simultaneously, Janet Yellen has been “extremely clever” in skewing the issuance calendar towards shorter-dated debt instruments, which has artificially lowered yields on 10-year notes. “We think this has taken almost 100 basis points out of the long end of the market,” he said, estimating that this has saved the US government $350 billion a year in interest charges.

The Bond Market is “Troubling”

Michael thinks the bond market is troubling from a number of dimensions, with the big question being, “Who’s going to buy the debt and at what price?” Because most of the funding has been done at the very short end of the market, pension funds have basically been squeezed out.

Inside the bond market, Michael sees “two disturbing currents.” “If you look at underlying policy rates, I think it’s very difficult for the Fed to get rates down meaningfully against an economy that is clearly very strong,” he says. “And with fiscal policy running up the clip it's doing, how on earth is the economy going to slow market? It's simply not.”

The other piece is around term premia:

Additionally, Michael points out that China and Japan aren’t buying US bonds anymore - hedge funds are. “And what's going on is they're using a basis trade,” he said. “In other words, they're going along the cash market, short futures and an arbitrage. That relies on stability in the bond markets and low volatility.”

The Hangover is Coming

So we’ve got a debt maturity wall starting, inflating nibbling away, and the Treasury issuing a disproportionate amount of short-term debt. “They're sort of losing their grip on the market,” Michael says. “There’s only a certain amount they can do. It’s like going on the booze and you keep drinking. You're going to get a hangover. At some stage, you've got to pay the piper.”

The Monetizing Debt Regime

 Michael says that the hands of policymakers worldwide are tied because “How can you raise interest rates and just increase the interest bill on government debt?” “This is the problem,” he says. “You’ve got a regime where debt is being increasingly monetized.”

💡 “The US may well be one of the cleanest shirts in the laundry, but this is a worldwide phenomenon,” Michael said. “And that's why I think what you've got here is a situation where underlying inflation is picking up. And that's why investors need these monetary inflation hedges in their portfolios, be it gold, be it Bitcoin, be it prime residential real estate, be it high quality equities that have got pricing power. These are critical parts of the asset allocation process now.”

To watch the full episode, right this way.

Enjoy,

Maggie

P.S. I’ll be going live with WisdomTree macro strategist Sam Rines over on Talking Markets shortly - at 4pm ET to be exact. You’re invited to join us to talk CPI, small caps, AI capex, and more - right here.

Important Disclaimer: It is crucial to remember that this article is for informational purposes only and should not be considered investment advice. Consult with a qualified financial advisor to assess your risk tolerance, investment goals, and determine if an allocation to oil aligns with your overall financial plan.