Liquidity Is Breaking And The Economy Is Next | Michael Howell

This episode features Michael Howell's stark warning that global liquidity is approaching a dangerous threshold, potentially triggering market instability and an economic downturn by September, driven by hidden central bank maneuvers and a looming debt refinancing wave with significant implications for all risk assets, including crypto.

Bank Reserve Situation: Approaching the Danger Zone

• Michael Howell, known for his deep expertise in global liquidity flows, opens by assessing the current state of bank reserves within the US financial system. While central bankers debate whether the system is in an ample, scarce, or abundant reserve regime, Howell argues we are rapidly approaching critical limits. He points to consistently widening spreads in repo markets as early warning signs of stress, suggesting policymakers should be concerned despite their stated desire to avoid a repeat of the 2019 repo crisis. Howell emphasizes that bank reserves are only part of the picture; the availability and quality of collateral are equally crucial, particularly as the repo market acts as the nexus for liquidity and collateral.
• Key Insight: Howell forecasts that, based on current Federal Reserve trends, the system could effectively "run out of money" by September 2024, marking a dangerous threshold.
• Technical Term: Repo markets (Repurchase Agreement markets) are where participants offer U.S. Treasuries or other high-quality securities as collateral to raise cash overnight. Stresses here often indicate broader liquidity shortages.
• Strategic Implication: Investors should closely monitor repo market indicators (like widening spreads) as lead signals of systemic liquidity stress, which could precede broader market volatility affecting crypto assets.

The "Pump and Dump": Unpacking Hidden Stimulus

• Felix asks Howell to elaborate on his concept of a recent "pump and dump" orchestrated by the Federal Reserve and Treasury. Howell explains this involved "Not QEQE" – liquidity injections outside the Fed's stated Quantitative Tightening (QT) policy, utilizing tools like the reverse repo facility rundown, Treasury General Account (TGA) fluctuations, and the now-defunct Bank Term Funding Program (BTFP). Concurrently, the Treasury, under Janet Yellen, heavily funded the deficit using short-term Treasury bills, which banks readily absorbed, effectively monetizing the debt. This combined hidden stimulus peaked at roughly $6 trillion in early 2024 but has rapidly tailed off, creating a sharp negative second derivative effect impacting markets and the economy.
• Technical Terms:
  • QT (Quantitative Tightening): The process where a central bank reduces its balance sheet, typically by letting assets mature without reinvesting the proceeds or actively selling assets, thereby removing liquidity from the system.
  • Not QEQE: Howell's term for Fed liquidity operations outside of traditional QE/QT definitions, such as RRP drawdowns or TGA management, which still impact overall liquidity.
  • TGA (Treasury General Account): The US Treasury's main checking account held at the Federal Reserve. Changes in its balance impact bank reserves and overall liquidity.
  • BTFP (Bank Term Funding Program): A temporary Fed facility created in March 2023 offering loans to banks against certain collateral valued at par, designed to ease stress after the SVB failure.
• Howell's Perspective: "This was extra liquidity that was flowing into the system effectively... what you can see over the course of 2024 is that has tailed off pretty sharply... it's that second derivative which is really important."
• Evidence: Howell presents charts showing this stimulus measure advanced by 9 months correlates with a slowdown indicated by the Philly Fed survey and an AI-based daily measure of world GDP growth, suggesting the stimulus withdrawal is already dragging on economic activity.

Clarifying QE: It's About Liquidity and Balance Sheets

• The discussion clarifies what Howell means by needing more "QE." He emphasizes the core issue isn't necessarily zero interest rates preceding asset purchases, but the need for more liquidity defined as expanding balance sheet capacity within the financial system. In a world dominated by debt refinancing rather than new capital investment, balance sheet capacity is paramount. Central bank balance sheet contraction makes it extremely difficult for the private financial sector to expand its own capacity to roll over the massive amounts of existing debt. Therefore, the Fed needs to expand its balance sheet to support the system's refinancing needs.
• Key Concept: Howell argues the focus should shift from interest rates to balance sheet capacity, as the modern financial system is primarily about rolling over existing debt, not funding new projects.
• Strategic Insight: Investors should focus less on the Fed's interest rate decisions and more on the trajectory of its balance sheet size and overall liquidity conditions, as these are the primary drivers in a debt-refinancing world.

The Debt-to-Liquidity Ratio: A Crisis Predictor

• Howell introduces a critical metric: the ratio of debt-to-liquidity, arguing it's far more meaningful than the commonly cited debt-to-GDP ratio. Historically, this ratio exhibits mean reversion. High levels (too much debt relative to liquidity) precede financial crises (debt refinancing crises), while low levels (abundant liquidity) fuel asset bubbles. Currently, after years of central bank liquidity injections and debt term-outs at low rates, this ratio is starting to rise sharply as the "debt maturity wall" approaches over the next 2-3 years.
• Data Point: The historical debt-to-liquidity ratio for advanced economies mean reverts around a 2:1 level. Projections show this ratio rising almost vertically soon due to maturing debt.
• Howell's Warning: This impending rise in the debt-to-liquidity ratio "is enough to end the bull market by definition" and requires close monitoring as "one slip could be a serious issue."
• Actionable Takeaway: Crypto investors should track metrics related to the debt maturity wall and overall liquidity, as a sharp rise in the debt-to-liquidity ratio signals increasing systemic risk that could trigger a deleveraging event impacting all risk assets.

Quantifying the Liquidity Gap: Why the Fed Must Act

• Howell quantifies the needed liquidity growth. Assuming government debt grows at roughly 8% annually (e.g., 4% deficit + 4% interest costs), system-wide liquidity must grow commensurately to ensure stable refinancing. This implies the Fed's balance sheet should ideally also grow around 8% per year in a steady state. However, it's currently shrinking or stagnant, creating a dangerous gap, particularly as bank reserves remain stuck near minimum required levels for parts of the banking system.
• Core Argument: Static or shrinking central bank balance sheets are incompatible with steadily growing debt levels in a system reliant on refinancing. The private sector cannot bridge this gap alone due to regulatory constraints and the central bank's ultimate control over base liquidity.
• Implication: The current Fed policy trajectory (even slowed QT) appears unsustainable given underlying debt dynamics. A policy reversal towards balance sheet expansion seems inevitable to Howell.

The Modern Financial Structure: Shadow Banks and Collateral Risk

• Howell presents his model of the post-GFC financial system, highlighting a crucial shift from traditional, regulated banks towards shadow banks due to regulatory arbitrage (e.g., SLR constraints making traditional banking less profitable). This system hinges on the repo market connecting global liquidity pools with collateral, which includes both public debt (favored by banks) and private debt (increasingly used by shadow banks, like CLOs). While central banks act as Lender of Last Resort for banks (providing reserves, deviation-suppressing), their role as Dealer of Last Resort (maintaining collateral values) is less defined, especially for private collateral held outside the main safety net.
• Technical Terms:
  • SLR (Supplementary Leverage Ratio): A US regulatory requirement forcing large banks to hold a minimum level of capital against their total assets, regardless of risk weighting, making holding low-risk assets like Treasuries less profitable.
  • Shadow Banks: Financial intermediaries (like hedge funds, private credit funds) conducting credit activities outside the traditional regulated banking system.
• Key Risk: The increasing reliance on private sector collateral held by shadow banks creates a pro-cyclical, "deviation amplifying" risk. An economic slowdown could impair this collateral's value, triggering a negative feedback loop and potential cascade, as this collateral isn't fully backstopped by authorities.

Repo Market Stress Signals

• Howell points to the spread between the Secured Overnight Financing Rate (SOFR) and the Fed Funds target rate as a key indicator of repo market tension. Recent data shows persistent bunching where SOFR exceeds Fed Funds, particularly around quarter-ends, suggesting either a shortage of high-quality collateral or a lack of liquidity. While not yet at crisis levels daily, Howell views this trend as a worrying sign that the market's "heartbeat" is becoming strained.
• Technical Term: SOFR (Secured Overnight Financing Rate): A broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. It's replacing LIBOR as a key benchmark rate.
• Howell's Interpretation: This isn't where stress starts, but where it ends up becoming visible. The trend of increasing tension is the critical factor.

Bank Reserves: Projecting the Crunch Point

• Analyzing US bank reserves, Howell shows they've largely flatlined since mid-graph, despite jumps like during the SVB crisis. He estimates the minimum adequate reserve level for the system, considering the uneven distribution between large and small banks (using a one-standard-deviation lower bound). Projecting forward, factoring in TGA drawdowns/rebuilds, the RRP rundown, Fed operating losses, and seasonality, Howell's model indicates bank reserves will likely fall below this critical minimum threshold around September 2024.
• Key Projection: The confluence of TGA rebuilding post-debt ceiling resolution and ongoing (even if slowed) QT is expected to drain reserves sufficiently to trigger significant repo market tensions by September.
• Actionable Monitoring: Investors should track the level of bank reserves relative to estimated minimums and the Fed's RRP facility balance (currently nearing depletion as a liquidity source).

The Inevitable Policy Response: Disguised QE

• Given the limited remaining capacity of tools like the RRP facility, Howell argues the Fed must eventually resume consistent balance sheet growth (around 8% per year) to match debt growth and ensure financial stability. He dismisses the Fed's goals of normalizing the balance sheet size relative to GDP or history as "completely mad" in the current debt-driven context. While acknowledging the Fed won't call it "QE" (suggesting acronyms like "QS - Quantitative Support"), the functional outcome must be balance sheet expansion via asset purchases or similar liquidity-injecting operations.
• Howell's Conviction: Failure to act preemptively will likely force the Fed to intervene "in size" later to bail out the system after another failure occurs.
• Contrarian View: Howell finds the Fed's desire to offload duration onto the private sector perplexing and potentially counterproductive, rejecting cynical interpretations that it's a deliberate attempt to crash the economy but highlighting the policy's inherent risks.

Debt Refinancing Challenges and Market Implications

• The conversation touches upon the immense challenge facing the US Treasury (now under Scott Bessent) in managing the debt refinancing wave, inheriting a situation skewed towards short-term bills by Yellen. Issuing long-term debt now is difficult without disrupting markets, especially with fewer international buyers (China, Japan stepping back) and rising term premiums globally due to increasing deficits elsewhere. A potential economic slowdown might lower yields, easing the burden slightly, but likely leading to a pronounced yield curve steepening.
• Technical Term: Term Premium: The extra yield investors demand to hold a long-term bond instead of rolling over a series of short-term bonds; reflects risks like inflation uncertainty and supply/demand imbalances.
• Market Outlook: Howell anticipates rising term premiums and a steepening yield curve if the economy slows and the Fed cuts rates, making long-duration Treasury issuance challenging.

Yield Curve Suppression and Its Consequences

• Howell details a fascinating analysis suggesting the true US yield curve has been artificially suppressed. By comparing the actual 10-year Treasury yield to a "bootstrapped" yield derived from government-backed Mortgage-Backed Securities (MBS, which have longer duration and more convexity), he finds a persistent gap of roughly 100 basis points. This gap correlates strongly with Treasury bill issuance, implying the scarcity of coupon-bearing Treasuries (due to Yellen's bill-heavy strategy) distorted the market.
• Technical Term: Convexity: A measure of how sensitive a bond's duration (interest rate sensitivity) is to changes in interest rates. MBS typically have higher convexity than Treasuries.
• Major Implications:
  1. No True Inversion: Adding 100bps back to the 10-year yield means the yield curve likely never truly inverted, making recession calls based on that signal potentially false flags.
  2. Understated Inflation: Adjusting break-even inflation rates (derived from TIPS) upwards by 100bps aligns them much better with consumer inflation expectations (like the University of Michigan survey), suggesting underlying inflation has been higher than TIPS implied.
• Resolution: This distortion likely resolves itself as term premiums rise, pushing actual Treasury yields closer to their "true" level.

Credit Market Deterioration Signals

• Despite tight credit spreads appearing "priced for perfection," Howell sees warning signs. Spikes in Treasury yield curve convexity (specifically, the 5-year yield relative to the 2-year and 10-year) historically precede credit market deterioration, and such spikes have occurred recently. Furthermore, corporate credit yields are trading through (lower than) mortgage yields, an anomaly given mortgages are government-backed. Howell attributes the tight spreads partly to the Fed's implicit backstop (post-2020 interventions) and scarcity of new corporate issuance due to prior debt term-outs.
• Key Indicators: Monitor Treasury convexity measures and the relationship between corporate credit yields and government-backed mortgage yields for signs of stress.
• Underlying Risk: Credit markets seem unprepared for a slowdown from ~7-8% nominal GDP growth to sub-4%, even if it's not a full recession. This poses a risk given the financial system's reliance on credit market functioning and collateral values.

World Risk Appetite Cycle

• Howell notes a divergence in risk appetite. While global liquidity momentum might be slowing but not yet declining sharply, his measure of the "world risk cycle" shows a marked deterioration, particularly among US investors, starting this quarter. He posits this might be driven more by the US economic slowdown (linked to the withdrawal of hidden stimulus) than by tariff uncertainty, as global risk appetite hasn't fallen as sharply.
• Insight: Risk appetite can diverge from liquidity flows. Currently, US investors appear to be turning risk-off faster than global counterparts, potentially reflecting specific concerns about the US economy.

China's Policy Shift and the Yuan-Gold Target

• China's policy is shifting significantly towards stimulus. After tightening sharply in late 2023 to defend the yuan against a strong dollar (causing a bond yield collapse and panic), authorities are now easing aggressively. This includes PBOC liquidity injections (estimated at ~$2.75 trillion annualized rate), pro-business rhetoric from Xi Jinping, and signs of stabilization in real estate. Howell argues the key metric to watch isn't USD/CNY, but the yuan price of gold. He believes China aims to devalue the yuan against gold (targeting ~26,000 yuan/oz, or ~$3600/oz USD equivalent) to combat debt deflation by inflating away the value of its excessive debt burden (estimated 30% too high relative to liquidity).
• Strategic Pivot: China is actively trying to reflate its economy and manage its debt overhang, potentially through currency devaluation against gold.
• Market Driver: Howell suggests the Shanghai Gold Exchange may now be a primary driver of the global gold price, with the yuan-gold price target influencing the USD gold price via the exchange rate. This explains gold's recent strength despite other factors.

Gold Market Dynamics and BIS Rules

• The discussion touches on unusual gold market activity, including massive imports into the US and settlement delays in London (T+6 weeks instead of T+1). Howell mentions upcoming BIS rules classifying physical gold bullion (but not derivatives) as a Tier 1 asset for banks starting this summer. This could be driving a significant shift from futures/derivatives into physical bullion, explaining the large flows and potential logistical strains.
• Regulatory Impact: Changes in bank capital rules (BIS) appear to be significantly impacting physical gold demand and market structure.

Bitcoin: Liquidity, Risk Appetite, and Gold

• Howell presents analysis showing Bitcoin's price movements are significantly influenced by global liquidity (with a lead time of roughly 13 weeks, confirmed by Granger causality tests), investor risk appetite, and the gold price. A VAR model suggests these three factors are the primary systematic drivers. Bitcoin and gold exhibit a long-term co-movement but with leads and lags (an error feedback process); gold led recently, while Bitcoin led in late 2023. While rising liquidity offers a potential near-term tailwind for Bitcoin, Howell remains cautious about the medium-term (6-18 months) liquidity outlook.
• Bitcoin Drivers: Unlike gold (primarily a liquidity/monetary inflation hedge), Bitcoin is sensitive to both global liquidity and broader investor risk appetite (e.g., S&P 500 movements).
• Long-Term View: If debt grows at 8% annually, liquidity must follow for stability, creating a long-term tailwind for monetary inflation hedges like gold and Bitcoin. Since 2000, US government debt and the gold price have both increased roughly 9.6 times, demonstrating this link. Bitcoin has outperformed but follows similar fundamental drivers.

Conclusion and Outlook

• Michael Howell concludes with a cautious outlook, anticipating potential near-term market bounces driven by residual liquidity, but significant risks emerging in the fall (around September) as liquidity tightens further and the debt maturity wall looms. Uncertainty will persist until the Federal Reserve pivots towards sustained balance sheet expansion.
• Core Strategic Insight: The global financial system faces a critical juncture driven by unsustainable debt growth relative to current central bank policies. A liquidity squeeze appears likely by late 2024 unless the Fed reverses course.
• Actionable Takeaway for Crypto AI Investors: Monitor global liquidity indicators (reserves, repo, Fed balance sheet), credit market stress, and risk appetite signals closely. Recognize Bitcoin's dual sensitivity to liquidity and risk sentiment, positioning accordingly for potential medium-term headwinds despite possible short-term rallies, while acknowledging the long-term tailwind from necessary monetary inflation.