Interview Michael Howell, CrossBorder Capital

Michael Howell: I think it's worth drilling into what it means and why it's important. The fact is that markets are moved by money.

What investors need to try and understand is that flow of money. We track money flows through world financial markets, which is what we call global liquidity. Liquidity moves markets.

The big change that we've probably all witnessed in the last, 30, maybe even 40 years, is that money flows in markets have come to dominate price movements.

Understanding investment now is not so much about going down to the micro or drilling into what is the value in a particular stock or security, it's much more about understanding these money flows, what big investors are likely to be doing.

The list would include hedge funds, sovereign wealth funds, and central banks.

At CrossBorder, we monitor their participation or transactions in markets and track these movements around the world.

Interviewer: Are you highlighting you're not just talking about changes in interest rate policies between central banks, your analysis goes much deeper?

Michael Howell: Yes, exactly. The key thing is to ask: what do interest rates really mean?

And that's a puzzle. I scratch my head and don't really come up with a sensible answer. If you go back to what the textbooks would tell you, they will say you've got a regime where households are in surplus. They've got surplus savings.

The corporate sector has got capital spending to undertake, it's in deficit. It borrows from households, and, essentially, interest rates are the arbiter between the two. That makes perfect sense.

The trouble is we don't live in that world anymore. We live in a world where the entire private sector is in surplus. Corporations are sitting on big cash piles. They are going to invest whatever, regardless of interest rates.

The big deficit sector in the economy is the government sector, and the government is basically transferring interest payments to the private sector, because it is in debt, and therefore, if interest rates go up, in theory, private sector incomes go up.

You can argue the complete reverse of what the textbooks tell you. Higher interest rates are a source of stimulus, not a source of contraction. And that's really the puzzle we've got; the whole world has turned topsy turvy.

The other thing to think about is capital markets today are not about raising capital for new investment projects. The only large scale investment that's been going on, frankly, is in China, and interest rates are not really the thing that determines the investment cycle in China.

So, what are financial markets doing in the West?

They're principally refinancing the huge debts we've got, and those debts basically need liquidity, or balance sheet capacity, to be rolled over, and that's why monitoring liquidity is really crucial.

Huge global debt underpins need for liquidity to refinance 

Interviewer: Can you add some numbers around the extent of that debt that needs to be refinanced, and how soon it needs to be refinanced?

Michael Howell: Worldwide there's about US$350trn of debt. It's mind blowing. It's a huge amount. And you think world GDP is about US$120trn?

You’re talking about pretty much three times, which triggers a large amount of debt to refinance. The pool of global liquidity is touching US$200trn.

It's big and, broadly speaking, what we need is a ratio of about two times for financial stability.

In other words, you need two times debt per unit of liquidity to mean the debt gets refinanced. If you've got a US$350trn stock of debt, and you assume the average maturity of that debt is about seven years, you're talking about US$50trn a year of refinancings alone.

This is obviously a gross amount, but it's on top of what net debt is being taken up as well.

You’re looking at a debt pile that is just basically turning over enormously every year, and capital markets are basically swallowing that, and they need liquidity to operate.

If you don't get the liquidity and if the debt liquidity ratio skews away from its normal levels of two times, you see financial crises when it's too high, and you see asset bubbles when it gets too low.

Interviewer: We're going to have a potential change at the head of the Federal Reserve, Kevin Warsh, and he's been quite vocal, as has Treasury Secretary Bessent, about shrinking the US government balance sheet. Is it a more ideological rather than a practical thing they'll be able to achieve?

Michael Howell: Correct It's pure nostalgia. The fact is a lot of these policymakers grew up with small central bank balance sheets. I think you can understand the sentiments of the US administration, saying maybe the footprint of the Federal Reserve or the remit of the Federal Reserve seems to have grown enormously, inordinately, maybe because they tend to be going down many different rabbit holes rather than doing what they should be doing.

I kind of sympathise with that.

But the fact is you need a big financial sector balance sheet to roll this debt over. And what governs, or who governs, the size of the financial sector balance sheet?

It's the central bank or, in this case, the Federal Reserve.

If you look at the math behind this, what you've got is federal debt. But the main role of the central bank is not about inflation fighting or about employment. It's all about maintaining the integrity of government debt.

They need that sovereign debt market to function, and believe me, if there are any problems, central banks will come in with alacrity.

Now that is a big ask, because the size of the federal debt pool has grown five times since the GFC. So, this is a big change, and the dealer capacity of the market has probably halved.

In other words, banks have reduced the size of their dealing operations, which means the Federal Reserve is already on the hook time and time again whenever you get dislocations in the markets.

The problem as well is we've had, on top of the covid crisis, since the GFC crisis, collateral become really the centrepiece of lending markets.

Close to 80% of all lending in the world economy now demands some form of collateral. That collateral is typically a US Treasury bond. That's the main form of collateral that financial markets tend to operate with.

In other words, to borrow from a dealer bank, you need to post Treasury collateral, and they will give a haircut to that, and you can borrow.

The haircut may be, let's say, for example, if you post US$1,000 of debt, you may get a haircut of 10%, which means you can borrow US$900 from the bank. That haircut will vary according to conditions, but the whole process of using collateral means the system is increasingly pro cyclical.

What you've got is, first of all, a bigger cycle, and secondly, you've got smaller capacity among dealer banks, and therefore the Federal Reserve is on the hook more and more. That's why you've got to have an active Fed and a large balance sheet to operate with.

The whole idea of shrinking the balance sheet is nostalgia. There is some talk or debate about whether the Federal Reserve can actually shrink its balance sheet because bank regulations have changed dramatically, which means the banks don't have to hold such big cushions against volatility.

They can do that, but by doing that you're actually inducing more leverage into the system for the sake of actually getting a smaller Fed balance sheet.

That doesn't seem to be sensible policy making, as far as I can see.