Will Central Banks Use QE to Prevent a Liquidity Crisis? (w/ Michael Howell)


MICHAEL HOWELL: I’m Mike Howell. I’m Managing Director of Crossborder Capital. We’re a fund management and research company
based in London. My background prior to that was that I was
at Salomon Brothers involved in research. And what we focus on almost entirely is global
liquidity and capital flows worldwide. We think that the world economy is clearly
stuttering. It needs a boost. Central banks have been behind the curve. They’ve basically been tightening too much
collectively over the last few months. And what they’re going to have to do is to
embark on a major easing program. In other words, another QE. That is very bullish for gold. And it’s pretty bullish for cryptocurrencies,
too. Yeah, I think one has to go back actually
quite a long time or one’s going to look at what happened to China starting in 2001, when
China was allowed into the world trade organization. As a result of that China built up a huge
trade surplus over time. It developed Chinese economy. China became very, very export-driven. And the US accommodated China, accommodated
Germany too. But effectively, China was being accommodated
by the US trade deficit. America is now saying enough is enough. They’re no longer prepared to accommodate
these big deficit diet China surplus. And this is the background to the tariff dispute. China was reacting to that. America imposed 10% tariffs, I believe, on
the 17th of September, within five days, China went and started to tighten monetary policy. Through October, China hit the monetary base
very, very hard and curtailed liquidity injections into Chinese money markets. We’ve seen the biggest slump in liquidity
in these Chinese money markets that we’ve seen for five years probably, and effectively,
that is slowing the economy hard, if you look at the backdrop, not only is Chinese manufacturing
slowing down significantly in the Chinese economy, but China dominates global value
chains, in other words, supply chains globally. And as China has slowed down, world exports
have also shrunk. And that has hit manufacturing companies worldwide,
but particularly in those locations that are involved in these supply chains. In other words, Japan, Taiwan, Korea, and
Germany. And those markets have been among the hardest
hit through the slowdown. America and service industry generally have
come out of this relatively unscathed. We’ve described the market outlook, in other
words, the stock market outlook as a market which is generally rising, but there is risk
of very sharp selloff, so what we call crevasses. To protect against that, what you need in
portfolios is effectively more bond convexity. Now, what’s the reason that you’re getting
these major selloffs? The major reason really goes back to the restructuring
of the global financial system, really in the wake of the GFC, the Global Financial
Crisis in 2008. We know there’s a big buildup of debt, but
debt needs to be refinanced. And the way to think about this is that the
world financial system is no longer a new money raising system. It’s effectively a refinancing mechanism. And if it’s a refinancing mechanism, what
you need is balance sheet. In other words, size. You’re not too worried about the level of
interest rates. So, the focus that the markets have and the
media has on interest rate cuts, we think are broadly meaningless. What you need to understand is the volume
of liquidity markets. In other words, balance sheet size, and in
particular, if the private sector is not coming up with balance sheet with central bank balance
sheet. Now, the key issue with the private sector,
which is what makes the whole system a lot more fragile, and contributes to these crevasses
is essentially that there was a shortage of safe assets in the system. Now, what do we mean by this? Safe assets are basically high quality bonds,
particularly Treasuries, particularly US Treasuries, but to some extent, corporate securities have
crept into that collateral mix. And the reason they crept in is there are
insufficient Treasuries in the system to provide collateral. Most lending now is collateral-based. And the reason for that is that what you have
is some very, very big new players in the markets, which we call corporate institutional
cash pools that basically come out of foreign exchange reserve managers in Asia, or they
come out of US corporates that are running major Treasury piles of cash. And what they need are safe short-term assets
to invest in in the money markets. And effectively, what’s happening is that
the bonds are being repoed and sold back to the CICPs, and that is the mechanism of refinancing. That works very well until you started collateral
problems. And collateral problems can occur if you get
an economic slowdown, for example, and the value of the corporate slice of that collateral
tranche comes under pressure. And then the whole liquidity mechanism collapses. That’s what we’ve seen a number of times. We saw it clearly in 2008 with mortgage backed
securities. We saw it again briefly in 2018 in December
when markets sold off. And what’s happened every time is the central
banks have come in, particularly the Federal Reserve. And that’s what happened through December
and January. And this is the basis for changing central
bank policy now. They’re beginning to realize that behind the
curve, liquidity has been way, way too tight. And now, what you’re seeing is central banks
beginning to ease but the leader is the People’s Bank of China. One of the ways that you can gauge the tightness
of the US system is to compare Fed Funds Rate, which everybody knows, with the term premia,
which is a slightly wonkish concept, but it’s the premium that investors prepared to pay
for long-term debt, long-term Treasury debt in the US, compare that to the Fed Funds Rate. Normally, the two move extremely closely together. But effectively in the last two years, term
premia have collapsed relative to Fed Funds. The collapse in term premier is equivalent
to a significant or it implies a significant monetary tightening. And that monetary tightening could be equivalent,
on our estimates, to a Fed Funds Rate which looks at around about 5% points. So way, way above reported levels. We think China has changed policy. And we think that the decisive move was around
mid-May. Now, the geopolitical background of that time
was right across the Chinese media, there are reports from Xi Jinping of three red lines
that the Chinese put down that say they would no longer negotiate on these three aspects
of the trade dispute with America. And those red lines meant that America effectively
had to now yield, China wouldn’t yield. And they’re not going to go back on this because
it would be a huge loss of face. In other words, this seems to be a very significant
watershed in the whole trade tariff dispute. What China did at the same time was to start
to inject liquidity back into their money markets. Effectively, what they’re saying is, we are
ignoring trade. We are starting to stimulate the domestic
economy. And we don’t really care if the yuan now devalues. The reality is here with us now because the
yuan has broken 7 against the US dollar. The magic 7 number. China reside to plow money back through the
money markets, liquidity injections by the People’s Bank that has persisted through May,
June, July and into August, and then they’re backing that up with other measures of fiscal
stimulus infrastructure programs and a lot more is likely in the pipeline. It is more targeted. It’s looking much more at infrastructure programs
as far as one can tell at the moment. It’s been given certainly to the state-owned
banks, and they’ll be generally at more into state-owned enterprise. Now, I want to stress here that this is not
a first best solution. This is the second best solution. China cannot continue to keep getting growth
through debt. We know that. But in the short term, this is the reality
that is happening. The Chinese economy needs to get between 6%
and 6.5% growth a year. China has estimated that the trade dispute
could cost it 1.5% points in GDP every year that this persists. It pushed the growth rate significantly below
their targeted rate. And therefore, they need to rebalance to get
the growth rate up. And hence the stimulus. Other central banks will follow the Chinese
lead simply because of China’s importance in the world economy and the importance of
the yuan in terms of a currency within these global value chains. Essentially, what you’re seeing at the moment
is as China has devalued and started to push in more liquidity, you’ve seen devaluations
generally of companion currencies or peer currencies against the US dollar. Other countries that are experiencing fallout
from the slowdown in China will want to try and boost their economies. And so we’re starting to see an increasing
debate in Asia and in Europe about easy monetary policy, already a lot of countries, for example,
Australia, are already doing that. The Federal Reserve is starting to cut interest
rates. But the most important thing that the Federal
Reserve can do is to expand liquidity. And that’s what it’s doing. Now the $64,000 question, which comes back
to the dollar is will America allow the US currency to appreciate? In other words, to put it another way, other
units to devalue again the US unit? And that with the answer that we think is
no. In other words, there’ll be a lot of pressure
being put on the Federal Reserve now to try and cap any dollar appreciation by printing
money. So effectively, we’re in a currency war, and
every currency, every economy is trying to leapfrog every other economy in terms of monetary
ease. Who wins out of that? Financial assets should generally do pretty
well. But the gold price comes out of this magnificently. And cryptocurrencies, which are pure liquidity
play should do extremely well. We call this Shanghai 2.0, which parallels
the Shanghai Accord that occurred in early 2016 following the G20 meetings. After those meetings, the G20 countries agreed
to stimulate their economies. And that broadly came through in terms of
central bank balance sheet expansion, or what we call QE. That launched an equity rally. Equity markets rallied strongly through the
back end of 2016, through 2017 and until they hit the hiatus in 2018. This is happening again. It is not coordinated this time around, but
it’s coinciding. It’s coinciding, because every country is
now trying to react to the slowdown, which we say is China-induced by basically trying
to stimulate their economies. And as each one tries to beggar thy neighbor,
so to speak, you get a general lift in liquidity worldwide. There’ll be a lot of pressure now for the
US currency’s rise, particularly if other countries are beginning to leapfrog the US
in terms of monetary easing. Therefore, the US has to keep up. And we think the pressures will start to build
on the Federal Reserve and the Treasury to try and maintain dollar parity at current
levels. And that will mean more monetary stimulus
coming through. So there’d be a lot of pressure on the Federal
Reserve to do even more QE. The point is against this ground, where generally
central banks are easing, this is the environment where equity markets tend to do pretty well. The best time for investors in equities are
when central banks are trying to stimulate economies that are very sluggish, such as
now. There’s a lot of competition now to see who
needs the most. And unless the US matches other major economies,
you’re going to start to see the US dollar rise. And that’s something that the administration
clearly doesn’t want, so they’re putting a lot more pressure on the Federal Reserve to
expand the QE programs. In terms of what this will actually mean,
we think there’ll be a significant easing of policy. To try and put it into perspective, probably
you’re going to see the equivalent of 100 basis points of US rates that will be bullish
certainly for the front end of the yield curve. It will mean that the yield curve likely steepens
and there is a chance that long yields could come down as well. But generally in this environment, when central
banks are trying to stimulate economies that are very sluggish, equity markets are the
big winners. Can we grow away out of a slump with credit
or debt alone? And the answer is probably not. But it does help to alleviate some of the
symptoms. What you’re likely to get is much stronger
financial asset prices. In other words, if you look at equity markets,
we can’t expect very much from the E, but the P can expand probably quite significantly. And generally speaking, as far as we can see,
well, the equity markets, while not being cheap, are comparatively inexpensive. What the big danger for markets is, is if
you get a major cracking liquidity as we saw previously in 2008. Now, we don’t think that’s on the cards, because
basically central banks are now beginning to act. That’s clearly something one has to watch
very carefully. Equity markets generally should do pretty
well in this environment. And if we’re correct, then what we’re looking
at is what we’ve termed a quick recession. In other words, investors prepare to look
through the outside. What you could easily get is a rally in value
with cyclical stocks which have clearly been under great pressure in the last 12 to 18
months. If you look worldwide, we think there is scope
for Asia to rebound based on this China reflation trade. And there is scope for Europe to rebound based
on what the ECB is likely to do. And in particular, when Christine Lagarde
gets into the helm of the ECB, it is likely that there will be some significant easy moves
there too. I don’t think there’s any good price inflation
in the system. We’re in a secular disinflationary environment,
which is being compounded by the fact that you’ve got long-term demographic problems. There simply is excess supply in the world
economy. Therefore, if liquidity goes into the system,
what you will get is further asset price inflation. And that’s the name of the game. There’s a good chance that bond yields could
go down. Now, this is a very dangerous trade. And I think that one has to say wholeheartedly
that buying bonds on negative and very low yields, on what could only be a 2, 3 or 5-year
view, is a crazy investment. But more and more investors are being browbeaten
into doing it. And the reason being is that there is a shortage,
a structural shortage of duration in the world economy, and particularly in the US system. And what that means is that the duration of
US pension liabilities is, for example, around 20 years, whereas the duration of the assets
is around 10 years. Now, a lot of pension plans have been holding
off, closing that duration gap, because they feel, they believe that bond yields already
are too low. But there’s a pain trade. And the lower the bond yields get, the more
that those plan sponsors will begin to capitulate, and start to buy more bonds. And that’s when you cook in a downside flip. So there’s a very clear asymmetry in the system,
because investors will be browbeaten into buying bonds as the yields drop. So it’s what he’s called in the pound’s negative
convexity. And that could be a problem. In other words, even though this environment
would seem to be unfavorable for bonds, because normally when central banks ease, yield curve
steepen. We could be in an environment where actually
the curve steepens, but across all maturities, the entire term structure drops. Commodities in our view should go up. And I think there’s a very interesting parallel
here with maybe what went on in the 1930s. Now, it’s always very dangerous to go back
and look at history. But one of the things that seems to be underway
is that the Trump administration is trying to divide the world in two. In other words, there’s a China-based system,
and there’s an American-based system. And in other words, there’s a lot more that
comes after this trade dispute. In other words, there’s attempts to try and
divide the world economy. And that was more or less what was happening
in the 1930s. In that environment, in the 1930s, there was
a scramble for resources. And that may be what’s on the cards now. A lot of variant TV commentators, I admit,
take a very different view. And they say, what’s going on is that you
will see commodity prices collapse if China is decoupled from the US system. It’s possible. There’s a logical case for that. But I think the opposite could happen. And with a lot of central bank liquidity being
plowed back into the system, I think it’s much more likely the commodity prices will
rise. The bellwether of that is the gold price. Gold normally leads other commodity prices
by around 9 to 12 months. And I don’t see any reason why that shouldn’t
happen now. There’s a real risk here of the US dollar
going up, and the dollar could easily overshoot. And that’s one of the dangers one’s got to
be alert to. Because a stronger dollar is unambiguously
negative for global liquidity, because it represents a big monetary tightening. We think the Federal Reserve will try and
stop that. It’s not in the administration’s interest
to allow the dollar to appreciate. And we think the pressure on the Federal Reserve
will build. Now one of the things one got to think about
in the background here, both for China and for the US, and for their political leaderships,
they face elections, both of them in the next 12 to 18 months, even Xi Jinping as it happens. Although he’s been installed as paramount
leader for arguably two decades, the reality is that he has to face the politburo for very
important debates in 2021. And China is trying to attain what is called
middle income status on World Bank numbers. And that has been a goal for the Chinese administration. Xi Jinping needs to get that. He needs growth. Trump needs to be reelected. He wants growth. So there’ll be a lot of pressure on the policymakers
to try and deliver growth for both those two economies. Trade is unquestionably the paramount issue. And markets are understandably skittish about
the worsening in the trade environment. One looks at the media, the odds continually
go up. Everyone’s trying to make this trade situation
look worse and worse and worse. But it’s been very much in China and the US’
interest to resolve the trade issue relatively quickly because both leaders need strong economies
going into 2020. What we think the outcome will likely be is
that probably by the end of this month, the end of August, come early September, the cost
will be set in terms of Federal Reserve ease. What you’re already seeing in terms of the
Federal Reserve balance sheet is a significant step having liquidity injections. China, as we noted, is already doing that,
we just got to wait for the ECB and Bank of Japan to come in. In other words, liquidity is starting to flow
into the system now and it normally tends to lead financial markets by around about
3 to 6 months. And therefore, certainly by Q4, markets, we
think should be beginning to move strongly upwards again. I think we ought to be under no particular
illusions that more liquidity doesn’t create growth. It will stabilize economies, it can flatten
out the cycle, but it doesn’t increase productivity in any way. And it doesn’t add to long term economic growth. In other words, what it does is it affects
in equity markets, the P multiple, it doesn’t necessarily affect the E in terms of long
term trend in E very much. The problem the world economy has got is it’s
saddled by debt, and it’s saddled by ageing populations. And the West is facing pronounced competition
from emerging markets and China. And that broadly is why we’ve got a secular
low growth rate. Liquidity is not going to change that, but
it may make us feel better. What we’re looking at is effectively a correction
of the selloffs. And if we are correct and we’ve called this
the quick recession, China is now easing and trying to stabilize its economy. What you will see is a lot of those markets
who have sold off very heavily in the wake of this China slowdown are the ones that could
bounce back pretty significantly. But Australia’s already had a very big bounce
through this year so far, but you’re likely to see Europe rebounding strongly, Korea rebounding,
and Japan. Punch line unquestionably is watch liquidity. Liquidity is the most important thing in the
global economy and global financial markets right now. What do you buy? You buy gold. If you look at global liquidity, it’s clearly
a very difficult thing to measure and to monitor. We do that systematically and professionally. So we cover 80 countries worldwide. But clearly, everybody can’t do that. What are the signs that liquidity is moving
into markets? Broadly, what we would say is to look at probably
three things. One is to look at the price of gold. Gold is a very sensitive asset class. Equally, I’ve mentioned cryptocurrency, but
let’s stick with gold. Gold, if gold goes up, it’s a sign that liquidity
is moving into markets. The second thing is to look at the slope of
the yield curve. Yield curves always steepen 6 months after
liquidity conditions start to improve. And that is a rule, which has worked for 3,
4 decades. It’s a very clear rule. Steepening yield curves mean more liquidity,
flattening yield curves mean tightening liquidity. Yield curves at the longer end of markets,
so looking at the 5 to 10-year spreads or 35 spreads already beginning to steepen. And that’s a sign that liquidity is bottoming
out and picking up. And the third thing to look at, which is sign,
if you like, if tension or stress is the corporate credit spread in the US. And the reason for looking at that is if that
spread begins to widen out, there is a risk of a crevasse vast in markets, as we warned,
because the whole collateral system is fragile and it rests a lot on the integrity of US
corporate debt, which is held as marginal collateral. So if credit spreads widen, then you could
see a pushback and liquidity could drop. So what I would like to see is rising gold,
steepening yield curves, and flat to narrowing US corporate spreads.

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