Strong global GDP is sucking liquidity from the financial system to the real economy

Interest rates -everywhere except China - are rising to match strong global GDP growth

Higher interest rates are coming, global liquidity has peaked and is now weakening. For one strategist at least, this will lead to an era of greater volatility that means investors should get more defensive with their portfolios.

This bearish view on markets comes from the founder and managing director of CrossBorder Capital, Mike Howell, who was interviewed on the Macro Voices podcast Thursday. With a long career of strategising, much of Howell's research is predicated on what he calls the "global liquidity cycle" - periods of roughly five years in which "the quantity and quality of money fluctuate" that often predict broader financial and economic cycles.

CrossBorder Capital's global liquidity index stands at 35, on a range from 0-100

Global liquidity measures the total ease of financing, availability of credit, and volume of cross-border financial flows across world markets. Howell's chart shows how global liquidity is on a weakening trend and he forecasts that interest rates will rise, it's simply a question of when.

Howell believes, despite the apparent reluctance of new Fed Chair Kevin Warsh to tighten monetary policy, he will be left with no other options, regardless of what his relationship with President Trump indicates.

"Central banks don't control interest rates. They may think they do, but the market controls interest rates, and it's the long end which drives the short end, not vice versa as the textbooks tell us," he said.

The veteran strategist firmly that believes no matter what tricks Warsh deploys, bond yields must rise to match the strong nominal GDP growth globally. What happens here, mechanically speaking, is that liquidity is sucked out of the financial system and diverted to the real economy, in Howell's words.

He expects that when Warsh makes his address at the Jackson Hole economic policy symposium on August 28, he must confirm tightening lies ahead. What troubles Howell is that central banks have been relying on issuance of bonds at the short end of the curve, buybacks and money market liquidity to maintain long-term yields. It's doing the job right now, he opines, but ultimately it risks higher inflation.

This concern is what drives Howell's recommendation to asset-allocate defensively: reduce credit exposure; err cautiously on long-duration bonds BX:TMUBMUSD30Y; maintain a commodity exposure; and seek out monetary inflation hedges such as gold (GC00).

While European liquidity broadly follows American trends, there is one sphere in which the liquidity cycle differs markedly: China, which is also travelling in the opposite direction, according to Howell. In recent years, the People's Bank of China has maintained a very tight liquidity and as a result China has very weak growth, he argues. No wonder its 10-year bond yield BX:AMBMKRM-10Y is languishing at 1.70%.

Now, though, China needs to foster some growth and he thinks the PBOC is "embarking on a significant liquidity expansion." Given the size and importance of the Chinese economy, this will "fuel further world economic activity and it will boost commodity prices globally."

Howell is of the opinion "there is a compelling case for higher oil (BRN00) prices to pick up sharply," but it's not just geopolitics driving that call. He observes the gold-oil ratio that has averaged around twenty times since 1970. Gold is currently forty-five times higher than oil. Even reverting to a more conservative thirty times, this suggests a crude price around $135 per barrel.

Gold/ Oil ratio (log terms)

Although inflation hedging is important, Howell regards China as the key determinant of the gold price. He observes the Shanghai Gold Exchange is "now the marginal pricer of gold worldwide," and the PBOC liquidity injections are likely to stimulate further domestic demand. It's worth noting, of course, that bitcoin (BTCUSD) and crypto are banned in China, so there is no competition as an inflation-hedge from that source.

-Jules Rimmer