Transcription
Kevin Walsh doesn't want to raise Fed funds, but he's certainly saying he'd like the markets to tighten for him. The question we're debating is how much can he allow those things to tighten? If the dollar goes up, that's clearly a wrecking ball for the world economy and world financial markets.
Do you think that gold and Bitcoin have those markets have seen this coming, so to speak? Gold is down nearly 30% from its highs earlier this year, while Bitcoin is down more than 50% from its all-time high last year. These two assets serve as a warning for what's to come for the rest of the markets. This is according to our next guest, Michael Howell, founder and managing director of GLI indexes, formerly CrossBorder Capital, and author of Capital Wars on Substack. When Michael was on the show 6 months ago with Wall Street near record levels, he told us to get defensive ahead of tighter liquidity conditions and much higher inflation. He turned out to be exactly right. And now, 6 months later, he's warning us that global liquidity is about to get even tighter still, and it's about to be a wrecking ball for markets to come. Stay tuned because Michael's been right before, and so you don't want to miss out on what he has to say now.
This video was sponsored by Kalshi, the largest prediction market in the United States. Unlike a sports book, you're trading peer-to-peer on real-world events, from economic data to political outcomes, and the price moves based on public opinion, not a house. Go to the link in the description down below or scan the QR code here, and use my code LIN, L I N, and new users will get $10 when they trade $10. And right now, traders are predicting that there's a 70% chance that the dollar index DXY will climb to above 104 this year. For context, we're currently at 101. So, why are traders so bullish on the dollar? We're going to get Michael's take on the direction of the dollar in this episode. So, if you put $50 down on the DXY going to above 104, for example, you could earn a payout of $78 if you're right, according to current odds.
Michael, welcome back to show. Good to see you again.
Very good to be here, David. It was good to
Let's start Yes, let's start by addressing the elephant in the room, which is why this year is not as bullish as last year. What happened? And I'm not talking about just the Iran war. I'm talking about the bigger picture here. Had the Iran war not happened, could we still see the S&P having fallen from its highs and gold significantly down from $5,000 an ounce and Bitcoin having come down 50% from its highs late fall last year?
Well, it's a complex question, but I think the short answer is we have still seen pretty much the same thing. I think the Iran tensions have had some localized effects and including that almost goes without saying. But it's actually had a somewhat complicated effect on China and the response the policy response that the PBOC, the Chinese Central Bank has been undertaking. I mean, we can dig into that later, but broadly speaking, I mean, what we're seeing is liquidity having peaked in late 2025. And liquidity has been slowing down. I mean, I'm not going to say that liquidity is falling in absolute dollar terms. That clearly is incorrect, but it's slowing down and that really matters in markets because liquidity is the marginal price of assets. And the reason it's falling is not because the Fed is stamping on the brake yet. I mean, Kevin Warsh has hinted he may have to do that. It's much more because the real economy is so strong.
Kevin Warsh and the Fed, let's let's discuss that and I want to come back to gold and Bitcoin and what they may signal given their market moves. Kevin Warsh and his first performance as FOMC chair at the first FOMC conference that he did chair, can you comment on his remarks there? Anything in particular stood out to you besides the fact that nine governors have voted to or wanted a rate hike?
Yeah, I think the fact is that if you if you look at what uh Kevin's Kevin Warsh's broad intentions are. Uh you know, he's doing some uh some necessary trimming of the Fed's remit. I mean, I think there's there's a lot of uh you know, cleaning that needs to go on in terms of what the Federal Reserve The Federal Reserve has very clearly strayed away from its normal normal remit. And I think Kevin is a good guy and he's going to basically put the Fed back on the uh on the on the rails. I think in terms of what he's saying, um I think there are two takeaways that I would bring out of that. 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? So, I'm not sure what Fed funds means. And I think Kevin Warsh rightly said that. I think the other thing he's saying is that he 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. The Fed is uh they So, the Wall Street is basically rocketing, whereas the housing market is soft. So, So, what do you do as a central banker? I think what he's doing is standing back and saying, "Look, I want the markets to tighten for me." And that's what we're seeing. Dollar's going up. Bond markets, yields are rising.
The expectation that the Fed will raise rates, how does that feed into your global liquidity cycles picture? So, you had mentioned on the show 6 months ago when you were on with me in December that low global liquidity uh was near the peak in the cycle, um and it's about 3 years into a typical 5-to-6-year bull cycle. How does the current situation with the Fed potentially tightening and the ECB already tightening fit into that picture? And by the way, is the Bank of England, where you're based, is that are they considering tightening as well? Very Any thoughts on
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. But I think the trend globally is there. That that's the
Do you have a chart for us, Michael, that shows the correlation between global liquidity and with the world wealth or any similar charts that could show us what happens once global liquidity takes a turn?
Yeah, let me um let me try and indicate if you can see um
Yes.
you can see these things. Let me Let me try and show you what what's going on in markets. Maybe the first thing to do is to look at this. This is looking at the growth of Fed liquidity. Uh this is in other words the growth rate of the pool of cash that the Fed is injecting into money markets. And you can see some of the background here in terms of the annotations. Uh the orange line is looking at a rate of growth. Uh you can see what happened immediately after the uh the COVID crisis when Fed liquidity growth was stunningly high at you know, rates of peaking at over 80 80%. Uh a six-month annualized clip. And then we start to see a very significant tightening. And you can see the wave that's followed since then. Uh the liquidity air pocket, the TGA rebuild. And then what you saw at the end of 2025 when the repo market started to feel the pressure of tighter liquidity. And I can evidence that just looking at this chart. Previously, this is looking at imbalances in the repo markets. The spikes that you see on that chart, think of this as a uh you know, a maybe a heart monitor. Uh this is showing the system is coming close to a coronary attack at the end of 2025. So the Fed comes in with more liquidity. And as I've indicated there, that's what was denoted by the RMP. This is yet another acronym that the Fed has invented, uh disguised QE program where they're injecting more liquidity in the markets. And you can see that jump in the orange line has basically, you know, helped to keep liquidity levels up, but notwithstanding that, the strength of the economy is meaning the net of the net is that we're still looking at some sort of inflection downwards. But it shows what the Fed, broadly speaking, has been doing through this period. Now, I think the other thing that you've got to you've got to start to think about is that, you know, what we're what we're looking at here is a monetary authority, and I'll extend that to the Treasury as well, that is very active in the markets. And either you're reassured that they're doing this, or you're concerned like us that cracks are appearing. And one of those cracks is clearly tensions in the repo market, as I indicated. So, this is what was happening as soon as liquidity started to tighten, you saw this thing this indicator jump. And the other thing to start looking at is what's happening to this indicator, which is the move index of bond volatility. Now, bond volatility is absolutely critical to the health of the monetary system. In other words, what that that is saying is if bond volatility is low, credit creation, liquidity creation actually works very well. But as soon as you start to see jumps in bond volatility, you get problems. The reason for that is the whole financial system today is collateral based. In other words, people have to post collateral before they can get loans, whether that's the simple example of a home mortgage, or whether it's uh looking at the government bonds used as collateral in financial transactions. And this is what the the Treasury is doing to try and curtail bond volatility in the markets. It's doing what are called buybacks. So, it's taking out of the system uh old stale what are called off-the-run bonds that are illiquid, and it's replacing them with new ones. It's just like swapping your uh your auto for uh a second-hand auto for a a new shiny one. That's what's going on and people prefer the new shiny ones. Therefore, volatility comes down and you can see that on this chart by looking at the cumulative uh pool of buybacks, the amount of buybacks that uh the Treasury undertakes and the MOVE Index. Every time the MOVE Index jumps, the Treasury comes in and starts to do more buybacks. So, they're controlling the system. Are we worried? Well, we should be concerned. Uh let's say that because these are all symptoms of late cycle phenomenon and Bitcoin and gold are simply uh yeah, barometers of that, too.
Can we expect the Federal Reserve under Kevin Warsh to embark on a tighter monetary regime when it comes to the size of the balance sheet? Recall that Kevin Warsh has been an outspoken critic of Bernanke's QE uh after the financial crisis of '08-'09. Uh I wonder if he will he will implement similar policies when it comes to shrinking the balance sheet or at least um have a similar kind of attitude that he did 15 years ago.
Well, the answer is the the short answer is no. Um the more complicated answer is that they may try in the longer term to get the Fed balance sheet down. That will involve a lot more reform of the banking system and it will have to reduce the amount of liquidity that banks are required to hold. Now, you can argue whether that's a good or a bad thing because we need cushion uh we need cushions in the banking system um and if he decides that that's what they want to do, the reforms could reduce those cushions, push more liquidity into the markets away from the banks, and that could mean that the Fed would be able to have a smaller balance sheet. But, that's a technical or slightly wonkish point. In the short term, the answer is no because they tried it once before in late '25. They started to take Fed liquidity down and as I said, if you look at what happens uh to this chart, look what happened in late 2015 when they started to shrink the balance sheet then, you saw problems in the repo market. And that is the issue that we've basically [clears throat] got. So, um, the short answer is no.
Okay. Let me flip over to my screen very quickly, Michael, if you'll allow me. So, this is a this is a a prediction from Kalshi. It's a prediction prediction market in the US. How high will the DXY get this year? And I bring this up because the probability of the DXY going uh, higher uh, has significantly jumped starting in the beginning of June. And now if you look at the way the traders are positioned, there is an overwhelming probability, 70% chance, that it's going to go above 104 uh, by the end of the year and 57% chance that it'll go above 105. So, basically 100% chance that traders are predicting the DXY will go higher from here, which is currently at a 101. We are at 101 on the Dixie. Why do you think markets are overwhelmingly bullish on the dollar this year? Is it because they think the Fed is going to be more hawkish than other central banks and so interest rate differentials will favor the US or do you see something else happening?
Well, I think you've got to put this in context. And let me uh, try and answer that question. Um, I'll go back to my sharing the screen. If you if I can um, just move forward in this. Let me just try and show the back. This is the US dollar. This is the trade weighted index going all the way back to uh, the mid-1960s. This is the DXY but actually it's the version that is uh, calculated by the BIS in uh, in Switzerland. What this shows is the underlying strength of the dollar basket. You can see that that is in an uptrend. Uh, that uptrend basically began just after the GFC. Uh, it is underpinned by capital flow. This is our estimates of capital flow into the dollar. You'll see this very buoyant. Why is that uh, occurring? It's occurring for a number of reasons. One is that that latest surge is because of uh, enthusiasm about US tech. US is clearly a leader in the tech space, but you've got other factors as well, most particularly the fact that after the GFC, bank and insurance regulations changed and basically underpinned the attractions of US assets for international banks and international insurance companies. And that's why a lot of money has flowed into the dollar. Now, that is coming on top of what you're likely to see, which is a Fed tightening. And this chart, which may be a tad wonkish, is looking at the deviations in the DXY away from its trend, the orange line, and the black line is a measure of Fed tightness inverted. So, if that black line goes up, that's saying that the Fed is going to tighten, and if the That would mean that the orange line starts to climb. So, I think perceptions of a much stronger dollar are likely uh a very likely. Uh the Walsh has indicated he wants the markets to tighten, and that really means a stronger dollar and rising yields or a steepening curve, for sure.
Which comes first, rising yields in the long end of the curve or a rising dollar? Or do they move together?
Well, I think they I think they they pretty much move together. I think that they they we can't avoid the two. But I think if you start to look at the underlying background, I'm going to get move on to what the fixed income markets are saying. Uh if I can just shift on there. This is the the chart that really everyone in the in the markets has got to start watching. I mean, this is a couple of days out of date, but it's basically showing us the slope of the Treasury yield curve. And what this is showing is in black the average slope of the curve, and in in orange, it's looking at the 10-2 spread. Now, the consensus view at the beginning of this year was overwhelmingly that we'd be seeing a steeper curve this year. What we've been seeing is a flattening curve, and that flattening curve is basically indicating that liquidity conditions are tightening. And that is the reality that we've got going there. Probably, almost certainly, the Fed and the Treasury do not want a flattening curve. They want a steeper curve. But the question is that it's very difficult to engineer that with the sort of tools they've got. The market decides at the end of the day interest rates. And the market at the moment is telling us that the curve is flattening and the long end is rising. And let me just illustrate where we're likely to be heading. The first thing [clears throat] to look at is this chart, which is looking at normal US GDP growth in black, which is a rolling average four-year average of normal GDP. So, that's with inflation and growth together. And the orange line is looking at the underlying level of yields at the 10-year tenor in the US Treasury market. What that's saying is those two lines pretty much match. So, if you think the economy is strong, we do. 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. There will be a little bit of respite because the Treasury and the Fed are trying to keep yields down, but you've got to think about yields rising not falling from here. And that's really the backdrop we're seeing.
HSBC has already warned that 4.5% is what they call the danger zone. Above 4.5% several institutions start to face significantly higher debt costs. Real estate people especially do not want the long end of the curve to go up. What happens to the economy at 6%? Michael.
Well, I'm not so sure that the I wouldn't say that 4.5 is a danger for the economy. I think 4.5 may be an increasing danger for the financial sector. And I think what you what you've got to differentiate here is the health of the economy from the health of the financial system. A lot of people used to draw a line at about 5.5% bond yield saying that the economy would would derail at those levels. I mean, that probably is not an unreasonable suggestion. But I think the danger point for the fixed income for the financial markets comes earlier than that because there's a lot of leverage in the system. And that's what we we've got to be conscious of. And those are the cracks that we've argued are appearing already. And that is why the Fed and the Treasury is so active. And so, I come back to my statement, either you're reassured that these guys are looking after our back or you're concerned that the cracks are beginning to get wider. And that's the problem.
All right. So, are you of the opinion that the economy, in particular the US economy, can withstand higher interest rates up to 6%?
Uh I think once we start to get above 5 and 1/2, I think it's becoming problematic. But, there's a lot of there's a lot of positive momentum in the economy, that's for sure.
Okay. Uh what kind of positive momentum can we see?
Well, I think there's two things very clearly. One is the fiscal deficit is high, large. I mean, we're still looking at 6, 7% of GDP. Uh that's rolling on, and that's clearly giving incomes and imparting, uh you know, demand into the economy. And secondly, there's this a massive uh capital capital spending boom. Uh and we can debate the merits or demerits of that. But, the fact is the capital spending booms are normally inflationary in the near term. But, this one is a big big one. And what we've got is, uh you know, strong growth as a result.
Speaking of inflation, today's uh core PCE number came out in the US. It core PCE hit 3.4% in May. This is the highest reading since October 2023. This is the Fed's preferred gauge of inflation. Now, uh this is important because now we finally have, I guess, some data or some evidence to conclude or to show that uh oil prices have impacted other sectors of the economy. And so, goods and services outside of oil and food have also shown some some tension in rising. Uh what do you make of today's print?
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. It may be coming down, but it's not coming down fast and so underlying inflation pressures are clearly there and therefore the Federal Reserve has got to act. Kevin Warsh doesn't want to raise Fed funds, but he's certainly saying he'd like the markets to tighten for him. The question we're debating is how much can he allow those things to tighten? If the dollar goes up, that's clearly a wrecking ball for the world economy and world financial markets. So, they can't allow that to go up too far and the bond market clearly impacts the domestic economy and domestic financial sector. Higher is not so good and we've got rising yields already.
Michael, we haven't had the Fed funds rate rise since 2022. Back then, that was terrible for all markets, stocks, bonds and gold alike. Investors are just worried about this being another 2020 2022 situation. Can you comment on similarities and differences?
Yeah. Best way to gauge this is look at this chart I just put up. This is looking at the 2-year Treasury note yield in orange and the black line is the SOFR rate. SOFR is the is the uh dominant market rate in the US markets. It's the repo rate. Most borrowing comes through repo, so this is really the key rate rather than Fed funds. Fed funds or the Fed is trying to influence this as best it can, but this is the market set rate. So, the black line is what the market is is saying. The orange line is expectations that are embedded in the Treasury term structure. 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. Uh and that's the pressure. That's the pressure that Kevin Warsh and Scott Bessent uh basically fighting at the front end of the curve.
Ultimately, then, do you think that gold and Bitcoin have those markets have seen this coming, so to speak?
Yes. I think the Bitcoin is the the the baro- 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. Uh the gold price is a little bit more complicated, and I just want to explain maybe what's happening in the gold market, because it's not maybe obvious from first sight. Um and I'm going to start with with this chart. This is looking at what the People's Bank of China has been doing. The People's Bank of China, uh in our view, is undertaking a policy where it is deliberately devaluing the internal, I'm stressing the internal value of the Chinese yuan. They have a huge debt problem. That debt problem is saddling the economy, it's slowing growth, it's im- it impairing the performance of China. And they need to get that out as soon as they get rid of that as soon as they can by basically lifting levels of nominal uh incomes, prices, etc. And they do that by devaluing internally, domestically, the yuan by printing money. China, remember, has capital controls, it has a huge trade surplus, it has compliant state banks, so it can control the external value of the yuan uh more successfully than maybe at first thought, maybe people would think. And therefore, this internal devaluation is is They have been doing that since early 2023. The chart shows the rapid increase in PBOC liquidity injections to basically for that goal. 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. Have they done that before? They have used the PBOC to cool the economy temporarily. They did that in 2008 ahead of the Olympics in July-August of that year to basically prevent pollution then damaging the showcase event. So, they've got form. They've done it again. What you can see in the latest data is some evidence of a flattening out of that of that of that injection. This is a blow-up of the previous chart or this is showing cumulative net liquidity injections into the system and what you can see is that peak occurring and you've seen the decline ever since and the latest data is showing that there is a stabilization. So, it looks as if China is re-liquefying again. Why does that matter? Because if you track PBOC liquidity with the gold price, it almost matches one for one. This is gold measured in RMB yuan on the right hand scale in orange. The black is PBOC liquidity. And what you can see is as the PBOC injected huge amounts of liquidity into the Chinese system, Chinese residents needed monetary inflation hedges. They were buying gold furiously, hence the Shanghai Gold Exchange has been the marginal price of gold worldwide eclipsing COMEX and London. That is the story on gold. 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.
The great debasement is yet to come. That makes me wonder and looking at these slides it makes me wonder there was a time not too long ago when journalists were focused on the great race to the bottom for all fiat currencies around the world when people were trying to countries were trying to weaken their currencies as much as possible to strengthen their own export sectors. Now with more protectionism in place all around the world, I wonder if that sentiment is still alive. And if so, what will happen to hard assets like gold? Because if no one's trying to keep their currencies and fiat currencies debased and low, then presumably hard assets like gold will have a harder time justifying valuations at current levels. What do you think?
If that's the case, that's absolutely true. I I wouldn't I wouldn't deny that. I think that that that could be what's happening right now. There's a there's a good argument for that because many central banks are starting to turn towards tightening on top of as I say strong demand for liquidity from the real economy. And the point there is that all money that is anywhere must be somewhere. So if it's in the real economy, it's not in financial markets and financial prices are suffering. Hence the fact that Bitcoin and gold are going down and hence the fact that the yield curve is flattening. 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.
What does happen to Wall Street in a yield flattening, higher inflationary and higher long end of the curve kind of situation here?
Well, 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.
[clears throat]
Um do the federal authorities want that to happen? Probably not. Uh my view through this year, I mean rightly or wrongly, uh we're halfway through is that what you'd see from Wall Street in 2026 would broadly speaking be a range-bound market. There'd be volatility, uh but it would really go sideways because the authorities wouldn't be tightening that aggressively. Uh and I think that's still the case. But, I think as we roll the clock on, uh the odds are that liquidity conditions are going to tighten more and more and more. Uh and that that projection uh becomes, you know, maybe challenged by year end or into '27.
Okay. By the way, how much um Well, sorry. What is your view on gas prices right now? Uh we had a bit of a reprieve after an MOU between Iran and the US was signed late uh last week. However, a ceasefire was shortly after broken. Now, there's confusion as to whether or not the Strait of Hormuz is open or not, but there isn't any confusion as to what the oil price is doing, which is still down from before the MOU was signed. I wonder how long it will stay lower at around $70 a barrel. What do you think?
Well, I'll give you my answer, which is probably a controversial one, but let let me try. First of all, you need to think of this chart. This is looking at the global liquidity cycle. This is what we've been talking about in the background. This is showing in black the rate of change of liquidity uh going through traveling through world financial markets. Uh the dotted red line is a sine wave we put on top of that, which refers to a 65-month cycle. Now, to answer the question specifically, if we come on to what's happening in oil, let me start with this chart. This is the gold-oil ratio. This is something that economists dismiss, but I think that as a market prac- prac- practitioner, this is what people are going to start looking at. Uh this is from experience what matters. And this shows over the very long term the ratio between a um an ounce of gold and a barrel of oil has been constant near constant at about 20 times. So, back in 1970, gold was 35 bucks an ounce, oil was 2 and 1/4 dollars a barrel, 20 times. 1990, 400 200. 2015, 1,000 versus 50. 2022, 2,000 versus 100. That's the 20 times. So, if you look at where we are now, we're up at around 40. Actually, we're we're slightly above that now because gold has fallen oil has sort of stabilized. So, what we're looking at is probably about a 45 or so level. But, what you can see is that that ratio mean reverts. Now, if you hold that thought and say, "What is the gold price?" We think probably Well, I mean, maybe not unreasonably that gold is going to be elevated in the medium term because of all this debasement, either current or future. And therefore, let's take as a minimum $4,000 an ounce of gold. If you believe that 20 times is the ratio that you've got to start factoring in here of the gold-oil ratio, simple math says that $200 a barrel of oil. Oil looks very, very cheap against other commodities, and it looks cheap against gold. Now, I'm not necessarily saying that 200 is a prediction or a forecast, but I'm saying this is the triangulation that comes out of it. And what you've got to expect is either you get $200 a barrel, the gold price collapses, or the oil-gold ratio must climb. It's one of those three factors. The gold-oil ratio is a technical coefficient must relate to the underlying cost of extraction of these commodities, and therefore that doesn't change very often. The gold price is something that is determined by the market and by monetization, which leaves the oil price as a residual. And therefore, that's a question that one we've got to ask. 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. What this shows is that the gold oil ratio tends to move with the liquidity cycle. Interestingly, it goes up sharply at the beginning of the cycle. Why? Because the gold price goes up. Uh liquidity drives gold higher. And then at the end of the cycle, the gold oil ratio comes down. Why? Because demand for uh demand for energy and demand for commodities is so strong from the real economy. And liquidity is principally going down at that stage because the real economy has got such a big appetite, crowding out financial markets. And therefore, what you see is the gold oil ratio coming down. So, what we're looking at is a very, very normal cycle. So, I would not discount higher oil prices in the medium term. And I wouldn't discount higher commodity prices in the medium term cuz I think that's the background we're looking at. We're looking at economic strength. And this sort of deglobalization uh process, which is underway, and I think doubly underscored by the MOU that has just been agreed, uh that is meaning you're going to get a lot of duplication uh of uh of supply chains, of defense systems, uh capex, I mean, whatever. There's got to be a lot more uh investment spending worldwide. And that's going to be more more chips.
Just on this economic strength, can you flip back to the previous chart for gold and oil, please? Yeah, that that that ratio here. Um I have in front of me, and I can't overlay them right now, but I have in front of me the dates of US recessions. It's inferred by GDP-based recessions. Now, uh in almost every case where the gold oil in uh ratio has spiked, uh for the exception of 1990, there was a recession shortly after. It served as a pretty good indicator. I don't know why this time we're not getting a recession, or maybe we are. Can you comment on this?
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.
You you you referenced momentum earlier, one of which is uh fiscal momentum. The deficit is still high and widening as you say. What happens when we have a confluence of higher interest rates and still higher debt and higher deficits?
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. Uh the banks love short-duration debt. They buy it. But that's called monetization. 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.
Yeah. It will Can we have a scenario in which uh perhaps the Fed raises rates, uh but commercial banks still loan money uh in uh equal volumes or uh the rate of change of the commercial lending does not change from the previous? Is that possible?
Well, you'd have you'd really need a steeper yield curve. And that may not be possible in the environment you're saying.
I see. So, what we're saying is liquidity at all levels from the federal to institutional to perhaps even the consumer level is going to be weaker this year or dry drier this year compared to previous years. Is that correct?
was it was starting in the financial sector. Uh Fed liquidity, as I say, has been slowing down. There was a jolt upwards at the beginning of the year because of the tensions in the repo markets. Uh the Fed has clearly been alert to those tensions and has done this R&P program temporarily. But Fed balance sheet is slated to uh or growth in Fed liquidity, I should say, is slated to slow down. Uh financial sector liquidity, as a result of that, will be challenged. And then you've got real economy liquidity, which is currently demand is very strong. That's sapping the financial sector, but ultimately uh higher rates will start to quell that. So, you're looking at a progressive or sequence in uh of slowing liquidity conditions.
What does that mean, Michael, for uh investors? Uh what are the investment implications, uh going back to my Wall Street question, of uh this current situation that we're in, a flattening yield curve, and higher interest rates, and higher inflation?
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've 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. Um it's very hard to get more than 2% out of financial assets in the long term real. Um so, that's yeah, not not a bad bet.
I have two final questions, just bigger picture questions. If you were to explain to the layman at a dinner party, someone asked you, "Hey Michael, why are deficits around the world exploding? Not just in the US, but also in Europe, also in Japan, by the way, which is causing the Japanese yen to fall. Why are governments spending so much money right now versus prior years?" Uh how would you answer that question? It's a very complex question, but how would you narrow it down?
I think it's basically aging demographics in the West, uh requiring more welfare spending, more social security spending, more Medicare, etc. Uh the governments have made commitments that these are going to remain intact. Uh the underlying cost inflation of these programs is clearly higher than normal mainstream inflation, and that's why the government's bill is basically rising. On top of that, you've got to say that uh you know, we're we're overtaxed. Um I mean, you can put it, you know, maybe more bluntly to say that, you know, if you're on the Democratic side, uh no one wants to cut spending. If you're on the Republican side, no one wants to raise taxes. So, the answer is that the deficit just keeps rising. And that is the problem. You have to going to have to increasingly ask the bond vigilantes who control the markets to uh for funding, or you have to print it yourself. And neither outcome looks pretty attractive to me.
Yeah, what should be the fiscal priorities of governments uh in the in the coming decade? That By the way, this is you you're in the UK. I read and please uh correct me if I'm wrong, but I I believe I read that the the uh current UK uh spending for welfare has exceeded tax receipts. Is that true?
Oh, well, most certainly. I mean, it's it's obscene. I mean, what's going on? Um you know,
Okay.
it really is. I mean, this is a socialist administration that just wants to spend money and give it on welfare payments. I mean, the the UK is a you know, is there's a sort of laboratory here showing uh what's happening to the UK, how how to destroy an economy. And this is this is this is uh you know, just just watch. Uh watch it do it.
How how do you turn How do you turn that around? Because reducing payments on social security and welfare presumably would be unpopular, but at the same time, that that can't be sustainable.
Well, I mean, the answer is clearly isn't. And um you know, younger generations who have to pay increasingly pay the taxes are going to start rebelling against this at some stage. So, what governments have to do, they have to bite the bullet and they have to start pairing pairing down welfare spending. And this is this is going to be no one's clearly brave enough to do that, but that's that's the answer. You simply can't afford this level of welfare spending. It's absolutely crazy.
Okay. And my final question is your firm is called Global Liquidity Indexes. Explain to somebody uh why liquidity, global liquidity in particular, is so important in in predicting and explaining why other variables in the macroeconomy moves the way they do.
Well, I think they if I do my diagram, I'll use this one. I mean, this is basically saying that if you look at the liquidity cycle, which is the the schematic red line there, that's saying that liquidity, which is basically the flow of money through financial markets, precedes what happens in the real economy. It precedes everything. So, in other words, money drives markets in some form. And our view is that that's really the starting point. Economics is downstream of liquidity and geopolitics is downstream of economics. And it all starts with liquidity and liquidity is this in our definition is the measure of the flow of flow of money through global financial markets. And it's really as important as that. And that is how the world is being driven increasingly in the last 30 or 40 years.
Okay, very good. Well, I I've thoroughly enjoyed that conversation, Michael. Thank you so much for lending us your time. Where can we go to learn more about your work and follow you?
The probably the best way, David, is Capital Wars Substack. That's something we write two or three times a week giving narrative and providing data. Or if you want more intensive data provision, glindexes.com is the website. And we provide data feeds to institutions.
We'll put the links down below. Please do follow Michael in uh Capital Wars and on his website. We'll put the links down there. Thank you very much, Michael. Take care for now and uh we'll speak again soon.
Great, David. Enjoyed it. Thanks so much.
And thanks for watching. Don't forget to like and subscribe and use my code Lyn l y n when you sign up to Kauri. Remember, new users who use my code can get $10 when you trade $10. Link down below in the description or scan the QR code here to get started.