Massive Liquidity Shock Coming; Brace For 'Wrecking Ball' Warns Economist | Michael Howell

Central banks globally are moving toward tightening because most have pure inflation remits, and as inflation picks up, they are compelled to tighten.

“Yeah, I mean they I mean generally central banks are moving in that direction. I think that when you look outside of the Fed, most central banks have pure inflation remits or anti-inflation remits. And so as inflation picks up, they're more or less compelled to tighten. And that's what we're we're seeing more and more evidence of.”

Higher interest rates combined with higher debt and widening deficits create a compounding debt trap where debt grows exponentially, and this is being funded through short-term treasury bills at the front end of the curve, which requires banks to continuously roll over and purchase short-duration debt.

“Well, when you get that confluence, it becomes it becomes uh the whole thing begins to compound uh in a nasty way. Uh debt grows exponentially, and that's really the problem. And what you're getting increasingly, uh not just in the US but globally, is that um uh policymakers are funding their deficits at the front end of the market. They're issuing a lot more bills, I mean including the US has gone to an extreme in that sense, uh but they're doing short-term funding. And the question to ask everyone's got to ask is who buys that debt? And the answer is it's the banks.”

The 2-year Treasury yield is a superior predictor of actual short-term interest rates (specifically SOFR) compared to Fed funds rate expectations, as demonstrated by its track record correctly predicting rate rises in 2021-22 well in advance, and currently the 2-year is signaling that rates must go up.

“The orange line has always been a perfect, almost perfect predictor of market interest rates, very short-term rates. The SOFR rate is an overnight rate, the two-year is clearly a two-year rate. But what that's telling us, and it told us very clearly in 2021-22, that rates were going up, and it gave us that warning a long time before. You can see the track record is obvious there on the chart. Uh the two-year has been a very, very good predictor. What is the two-year telling us now? It's saying that rates have got to go up.”

This money reallocation from financial to real economy creates warning signals for Wall Street; asset price sequences matter, and gold/Bitcoin weakness historically precedes broader equity market stress.

“These are all symptoms of that particular process. And that would tell us that you've got to have a warning there for what's going to happen to Wall Street because Wall Street won't be immune from from these events. One's got to put this in context and there's often a sequence in asset price moves. This is why we're concerned.”

Kevin Warsh has questioned the role of the Fed funds rate as a single policy lever, which is correct because it's unclear what the Fed funds rate means in the modern economy where large corporations have gross margins of 50%+ and a government running large deficits receives stimulus from higher interest rates rather than experiencing constraint.

“Number one is that he questioned the the role of Fed funds uh in terms of a single policy lever. And I think that's absolutely correct because I'm not sure what Fed funds rate means in the modern world, to be truthful. Uh if you've got uh you know, huge AI spend, uh which is rocketing ahead, and these corporations with gross margins of 50% or more, what difference do 25 basis points make uh to their to their cap expense? Zero. Uh the other thing if you got a government which is basically in huge hock to the private sector, it's uh you know, giving a large intra playing a large interest bill to the private sector you know, every month. Uh if interest rates go up, that's actually a stimulus, isn't an increase in income, isn't it?”

China deliberately reduced PBOC liquidity injections starting March 2, 2025 (when Iran tensions escalated) to slow the economy and reduce oil demand as part of a deliberate policy choice, following precedent from 2008 when China temporarily cooled the economy ahead of the Beijing Olympics.

“What happened on March 2nd was a surprise and you can see but what has happened is that China has turned off the money tap. That is extraordinary. Why they did that is baffling but there's probably a decent reason and that decent reason is that that was when the Iran tension blew up. Now, what is China doing here and all of you what they're doing is they're trying to slow the economy deliberately to reduce oil demand.”

Bitcoin is an excellent barometer of US liquidity conditions, reacting closely to Fed liquidity growth; when Fed liquidity slows, Bitcoin suffers correspondingly.

“Bitcoin is a is a very good barometer of US liquidity conditions. It tends to react very closely to the fact global liquidity, predominantly Fed liquidity. So, if Fed liquidity is slowing down, you'd expect uh Bitcoin to suffer, and it it it is suffering. It's a very good barometer of that.”

Short-term government debt funding represents monetization, which historically leads to Main Street inflation; this is what Milton Friedman would object to, as the banking system becomes compelled to purchase government debt rather than extending credit to the real economy.

“And monetization, we know from history, is not a good thing because it leads to ultimately Main Street inflation. And you know, the arch monetarist Milton Friedman would be turning in his grave looking at some of these some of these data.”

In 2021-2022 when the Fed tightened, Wall Street declined 25% and Bitcoin fell 75%, demonstrating the asymmetric impact of tightening cycles on different asset classes.

“What happened in 2021-22 when the Fed tightened was that Wall Street fell 25% and Bitcoin went down 75%. So, you can see the impact this could have.”

The current debasement has been selective (primarily from China's internal devaluation), not broad Western debasement; the great debasement of Western currencies is still to come, driven by the future debt problem of the West (America and Europe), of which China's current debt problem provides a foretaste.

“There's not been a great debasement as many journalists have been arguing. There's been a selective debasement. The great debasement is still to come and that is because of the future debt problem of the West, America and Europe. The current debt problem of China is why we've had a gold market surging already. This gives us a taste of what could happen of course.”

Investors should shift toward defensive areas of markets, increase commodity hedges given embedded inflation concerns, and move toward shorter-duration government debt where yields of 2%+ (especially in TIPS above 2% real) are attractive compared to long-term financial asset real returns.

“Well, I think the I mean, for me, the short answer is you've got to you've got to keep moving into the defensive areas of the market. Um you also got to start thinking about getting some protection from commodities uh because if that is if inflation is an embedded issue, then that clearly is something to to bear in mind. And I would say to start moving towards shorter duration um government debt. I mean, that looks to be a fairly decent asset. I mean, you're getting you're pretty nice yields on that. Or even think about the TIPS market. I mean, TIPS market is yielding over 2%. Um and, you know, in an inflation environment, that's a that's a pretty good return.”

The US economy likely avoids recession despite oil price shocks and rising rates because the Federal Reserve is not tightening with the same alacrity as in past oil shock cycles, combined with underlying momentum from the fiscal deficit and capex spending, which are both resilient to rate increases.

“Well, I mean, the reason that you we've had recessions before is the Federal Reserve has normally been moved to tighten aggressively when oil prices have gone up because they're they're concerned about inflation. Uh the question is are they going to do it with such alacrity this time? It there's a question. And the other point is there's a lot of momentum in the economy right now from the fiscal deficit, which is likely unaffected by this uh and by um the capex spend, uh which likely is also unaffected. So, I think there's probably underlying momentum that may keep uh the US out of recession uh because the underlying trend in the economy be so good.”

Normal US GDP growth (inflation plus growth combined) is likely to be between 6-7% going forward, which implies a target of about 6% for the 10-year Treasury yield, with only temporary respite from Treasury/Fed efforts to keep yields down.

“We think normal GDP growth is likely set for a clip of between 6-7% going forward. Maybe a tad higher than that, but you know, the economy is on a roll at the moment and inflation clearly is a nagging problem. But that is going to mean that you're looking at something like a target of about 6% on the long on the long bond or the 10-year on the 10-year bond.”

Core PCE at 3.4% in May 2024 (the highest since October 2023) demonstrates an underlying inflation problem that extends beyond oil and food prices, with bond market break-even inflation rates (2.5% from TIPS) significantly understating actual broad inflation as measured by the GDP deflator (4-year rolling average).

“Well, I think the fact is that there's a there's an underlying inflation problem. Let me just give that evidence. This is looking at um the orange line is the break-even inflation rate from the from the TIPS market, that the uh Treasury inflation protected securities. So, this is what the bond markets are allegedly discounting in terms of future 5-year inflation. As you can see, that number is low, 2.5% but you look at the black dotted line, that is a 4-year rolling average of US inflation using the broadest measure of US inflation, which is the GDP deflator. There is a big disconnect between those numbers and I think that the dotted line is the correct number.”

Kevin Warsh doesn't want to raise Fed funds directly, but instead wants market-driven tightening through higher bond yields and a stronger dollar to reduce financial conditions without explicit Fed rate increases.

“Kevin doesn't really want to interfere uh with policy too much uh in terms of making a bold statement here again on Fed funds because you've got uh very uh discordant indicators...what he's doing is standing back and saying, 'Look, I want the markets to tighten for me.'”

Oil prices will likely remain weak in the near term but the medium-term outlook is elevated; the gold-oil ratio historically mean reverts to approximately 20x, and if gold reaches $4,000/oz (minimum estimate due to future debasement), this implies oil equilibrates around $200/barrel.

“Oil is weak near term, sure. I'll come quietly. That was not a great surprise, but it's the medium term that matters. And if you put this into context, which is why I showed that earlier chart on liquidity, this is the gold oil ratio plotted on top of the global liquidity cycle. Now, if you believe that markets go in cycles, some people do, some people don't. I'm a believer that they do follow broad cycles.”