Michael Howell Shares Why We Should Master the Liquidity Cycle to Predict Markets

Episode 689 of My Worst Investment Ever podcast, published on 24 May 2023, was such an interesting discussion with Michael Howell of Cross Border Capital that I tried to summarize below what he shared about global markets.

Understanding the liquidity cycle is crucial for investors as they navigate financial markets, with a focus on liquidity flow rather than interest rates. The global liquidity cycle has tightened, signaling a potential recession, but swift action and liquidity injections are easing strains. Collateral pools have overshadowed traditional credit availability in Eurodollar markets, and the transition from LIBOR to SOFR aims to improve transparency. US policymakers are vigilant in safeguarding Western markets and maintaining the dollar’s dominance. The Chinese yuan is unlikely to rival the dollar due to Saudi Arabia’s role, strengthening the dollar’s position.

The Significance of Understanding the Liquidity Cycle in Financial Markets

Understanding the liquidity cycle is essential for investors navigating financial markets. Successfully anticipating its future state can lead to profitable investment decisions. It’s crucial to shift focus from solely monitoring interest rates to examining the flow of liquidity within the system. Given the substantial global debt in capital markets, continuous refinancing is necessary. However, when liquidity becomes scarce, refinancing crises can arise, posing challenges to financial stability.

The current situation reflects a funding crunch rather than a credit crunch, primarily impacting financial intermediaries like banks. It falls upon monetary authorities, such as the Federal Reserve, to take responsibility and inject additional liquidity into the system. In a world where debt refinancing surpasses new capital raising efforts by a ratio of 7:1, the capacity of balance sheets becomes paramount. This highlights the significance of closely monitoring liquidity and emphasizes the need for central banks to address this crucial issue.

In conclusion, understanding the liquidity cycle is crucial for profitable investments. Investors should shift their focus from interest rates to liquidity flow. Global debt requires continuous refinancing, and scarcity leads to refinancing crises. The current situation is a funding crunch, impacting financial intermediaries. Central banks must inject liquidity and monitor balance sheet capacity.

Mitigate Risk through the Move Index, a Superior Alternative to the VIX Index

The global liquidity cycle has reached its tightest point, following a period of central bank policy tightening that has lasted around 15 months. It’s important to note that financial markets are forward-looking and may experience the impact of tightening policies before real economies do. The recession has likely already begun, though many individuals may not yet be aware of it.

The inflection point in the liquidity cycle occurred in October 2022, triggered by the British gilt crisis. Fortunately, swift action by US authorities helped prevent a global financial crisis similar to the one witnessed in 2008. While Fed liquidity injections had previously flatlined, they are now on the rise again, relieving strains in the money markets. Bond volatility, as measured by the Move Index, initially spiked but is currently showing signs of decreasing.

The Move Index, also known as the Merrill Lynch Option Volatility Estimate Index, serves as a gauge of implied volatility in the fixed-income market. It focuses on interest rate volatility and is derived from options prices on US Treasury bonds. This index provides insight into the expected magnitude of future interest rate movements and market volatility, assisting in assessing and managing interest rate risk. A higher Move Index indicates greater expected volatility in interest rates, while a lower index suggests lower expected volatility.

Disruptions in sovereign debt markets can lead to liquidity problems, impacting credit creation. It is crucial to closely monitor the Move Index and collateral values as important indicators rather than solely relying on the VIX Index.

The VIX Index, or CBOE Volatility Index, measures stock market volatility and investor sentiment, reflecting expectations of future volatility in the stock market over the next 30 days. Typically, the VIX rises during periods of fear or uncertainty, signaling higher market volatility, and falls when investors are more confident and anticipate lower market volatility.

Government and sovereign debt hold significant roles in collateralized lending and credit creation. Recent declines in government bond markets serve as indicators of potential liquidity issues. Understanding investment risks requires a focus on the Move Index and collateral values. Fortunately, the liquidity cycle is beginning to pick up momentum due to increased liquidity injections from the Federal Reserve and the People’s Bank of China.

In conclusion, the global liquidity cycle has tightened, signaling a potential recession. Swift action prevented a crisis, and liquidity injections are easing strains. Investors should focus more on the Move Index gauges interest rate volatility, than the VIX Index measures stock market volatility. Government bonds and collateral values are key indicators. Liquidity injections are boosting the liquidity cycle.

Collateral Pools Are a Key Indicator of Credit Conditions Beyond Interest Rates

Over the past decade, Eurodollar markets have experienced a decrease in significance. It is important to differentiate between credit flows in Eurodollar markets, which have significantly declined, and Eurodollar futures markets, which reflect hedging activities in sovereign bond markets.

In collateralized lending, a collateral pool refers to a specific collection of assets, such as government bonds, corporate bonds, and mortgage-backed securities, utilized as collateral for loans or financial transactions. The purpose of a collateral pool is to provide security to lenders in the event of borrower default. These pools are commonly employed to mitigate risk and offer favorable borrowing terms.

The prominence of collateral pools has overshadowed credit availability in traditional Eurodollar markets. However, Eurodollar futures markets remain substantial and are undergoing changes as the Secured Overnight Financing Rate (SOFR) replaces the London Interbank Offered Rate (LIBOR) in the United States.

The shift from LIBOR to SOFR is driven by concerns surrounding LIBOR’s reliability and potential manipulation, which is calculated based on estimates provided by a group of banks.

In contrast, SOFR is derived from actual overnight repurchase agreements backed by US Treasury securities, accurately reflecting the real cost of borrowing cash overnight with government bonds serving as collateral. This transition aims to establish a more reliable and transparent benchmark rate based on actual transactions, reducing susceptibility to manipulation.

In conclusion, Eurodollar markets have declined in importance, but Eurodollar futures markets remain significant. Collateral pools have overshadowed traditional credit availability. The transition from LIBOR to SOFR aims to improve reliability and transparency, with SOFR based on actual transactions and collateralized lending.

Expect US Policymakers to Safeguard Western Markets and Maintain the Dollar’s Dominance

Policymakers in 2023 remain vigilant about the risk of a banking or credit crisis, as it would benefit China and undermine Western financial markets. This vigilance makes it unlikely for such a crisis to occur this year.

The outlook for the dollar encompasses two aspects; its status as the international means of settlement and its value. In terms of its value, 2022 was focused on strengthening the dollar by reducing the Federal Reserve balance sheet, while in 2023, the Fed aims to weaken the dollar by increasing the balance sheet.

Although the dollar is currently in a medium-term bull market, it is expected to undergo a correction of approximately 10% this year.

The Bretton Woods system still influences the dollar’s role as the global means of settlement, where the US dollar holds a central position and is supported by institutions like the World Bank and the IMF.

While denominating trade in a different currency, such as the Chinese yuan, could have some impact, it is unlikely to significantly diminish the dollar’s dominance as the primary means of settlement.

The dominance of a currency as a means of settlement is also influenced by the payment mechanism, including trade credit. The rise of the dollar during World War I was attributed to American banks providing trade credit. China may challenge the dollar in terms of trade credit, but it cannot match the US as a global banker.

Maintaining the role of bankers to the world requires a country to have deep, liquid, and transparent financial markets, a strong banking system, and trust. These are areas where China falls short, making it challenging for them to match the US in this regard.

The US trade deficit is not solely reflective of industrial competitiveness but rather the efficiency of the US finance sector.

The dollar’s dominance can only be diminished if US finance encounters significant difficulties or falters.

In conclusion, in their efforts to safeguard Western financial markets, vigilant US policymakers will do what it takes to avert the 2023 banking or credit crisis, particularly because such a crisis would benefit China. The dollar’s value is expected to weaken after a period of strength, while its role as the global means of settlement remains entrenched. China faces challenges in matching the US as a global banker due to shortcomings in its financial markets. The dollar’s dominance relies on the efficiency of US finance, and any diminishment would require significant difficulties in the sector.

The Dollar Should Remain Strong vs. the Chinese Yuan Due to Saudi Arabia’s Role

It is highly unlikely that a surplus economy like Saudi Arabia would be willing to invest its entire surplus in Chinese financial instruments, posing a significant challenge to China’s ability to rival the dollar. This consideration makes it difficult for China to emerge as a strong competitor to the dollar, at least in the foreseeable future, possibly several decades.

Contrary to the potential for China’s dominance, the dollar may actually strengthen its position in the near term due to various fiscal considerations and the urgent need for forward-thinking solutions such as digital currencies. These factors highlight the importance of the US Congress addressing issues like the debt ceiling, as they profoundly impact international investors and the overall dominance of the dollar.

The dominant position of the dollar, which holds considerable sway in global financial markets, was solidified with the establishment of the Bretton Woods Agreement in 1944. This historical agreement has deeply entrenched the dollar’s status and influence, making it an incredibly challenging feat for any currency to overthrow its dominance.

In conclusion, it is unlikely to see the Chinese yuan rival the US dollar due to Saudi Arabia’s inability or unwillingness to invest all its surplus in Chinese financial instruments. The dollar’s dominance is expected to strengthen in the near term, emphasizing the importance of addressing fiscal considerations. The Bretton Woods Agreement has firmly established the dollar’s dominant position in global financial markets.

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About the show & host, Andrew Stotz

Welcome to My Worst Investment Ever podcast hosted by Your Worst Podcast Host, Andrew Stotz, where you will hear stories of loss to keep you winning. In our community, we know that to win in investing you must take the risk, but to win big, you’ve got to reduce it.

Your Worst Podcast Host, Andrew Stotz, Ph.D., CFA, is also the CEO of A. Stotz Investment Research and A. Stotz Academy, which helps people create, grow, measure, and protect their wealth.

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