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On My Radar: Felix Zulauf, Liquidity and Markets

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December 13, 2024
By Steve Blumenthal

“Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures.

It’s liquidity that moves markets.”

– Stanley Druckenmiller

Global Capital Flows and the Web of Complexity – at the end of the day, “It’s liquidity that moves markets.” 

I’ve shared Druckenmiller’s quote with you before, but it is paramount to understand today’s piece on global liquidity, so I’ve dusted it off the shelf. Why now? Liquidity is about to be tested.

Felix Zulauf was interviewed by Jack Farley this week. You’ll find my high level notes along with a link to the podcast below. I have followed Felix for years. You may have read him in Barron’s. He was on the famous Barron’s Round Table with other greats like Mario Gabelli and one of my hero’s, Bob Farrell. I subscribe to Felix’s institutional research service because I want to understand his perspective on global markets, specifically the central banks, the dollar, interest rates, gold, commodities, equity markets, and his European perspective on geopolitics. What does he see happening? What might I be missing? Where are the significant risks and opportunities? We’re going to dig into that today.

Before I do, however, I want to set the stage with a short story that illuminates the interconnected web of the global financial system. This story will serve as a good foundation when we turn to Felix. We are small players but meaningful ones nonetheless. Put on your macro-geek hat. Here’s the story:

Long ago, in a bustling port city, there was a grand marketplace where merchants worldwide came to trade. The goods they brought were diverse: silks from the East, spices from the South, and precious metals from the North. These merchants didn’t just trade goods; however, they traded promises. A spice trader may pledge his next shipment to secure a loan; a silk merchant might sell goods on credit and trust the buyer to pay later. In no time, the marketplace was awash with IOUs—promises to pay, backed by the hope that the promiser’s word was good. 

Now, imagine that the spice merchant’s ship sank in a storm one day, wiping out the ability to repay his debts. His promises were like threads in a vast trade web, connecting him to other sellers, lenders, and buyers. When the spice merchant’s thread snapped, it didn’t just affect him; the entire web shook. The silk merchant, who had loaned money to the spice trader, suddenly couldn’t pay his debts. The gold dealer, expecting repayment from the silk merchant, was short on funds. And so, the ripples spread far beyond the original loss.  

Ancient marketplaces offer a lens into our modern financial world today. The “web of global entanglement” in our financial markets is infinitely more complex, woven together not by spice or silk, but by banks, counterparties, and capital flows. Here’s how it works:   

Banks in one country lend to companies or governments in another. These loans may be denominated in different currencies, requiring currency swaps to manage exchange rate risks. Investors in Europe might buy U.S. Treasury bonds, funded by borrowing yen from Japan thanks to Japan’s famously low interest rates. Meanwhile, smaller nations with emerging markets may attract foreign capital for infrastructure projects, assuming that global liquidity will remain abundant.   

As in the old marketplace, however, the global trade web is fragile. A sudden change- a sharp rise in U.S. interest rates, for example- can tug a single thread and cause tremors throughout the system. Higher U.S. rates may strengthen the dollar, making it harder for countries or companies with dollar-denominated debt to repay. Banks and funds exposed to these borrowers could face losses, leading them to tighten their lending or sell assets, further destabilizing markets around them. 

The counterparties (the other parties in every financial transaction) are critical in this web: a European bank might rely on a Japanese bank to fulfill a transaction agreement. If one side can’t deliver, the ripple effect can spread through countless connected institutions. This is why the disorder of one major player, like a global bank, or a government, can send shockwaves across continents. 

Capital flows add another layer to this entanglement. By nature, money doesn’t sit still—it seeks returns. A change in one market, such as a central bank raising interest rates, can redirect global capital like a sudden shift of wind. Funds might flow from emerging markets to safer assets, causing currency devaluations, inflation, or even financial crises in the affected regions. 

When people talk about the “web of global entanglement,” they describe this intricate, interdependent ecosystem. Each thread- whether it’s a loan, a trade, or a financial contract- links one party to another in a chain that connects the entire world. The benefits of this web are immense; it enables capital to flow where it’s most needed and fosters global growth. The risks are just as significant, however. As we’ve learned, disruption in one corner of the web can reverberate far and wide, reminding us how fragilely interconnected we are. Taxes, tariffs, and currency fluctuations all impact the web. 

The story of the ancient marketplace is a timeless lesson. The web of global entanglement, while a marvel of cooperation and innovation, requires constant vigilance and resilience. It reminds us that in finance, as in life, we are all connected. 

Although most of the time it’s business as usual, markets can grow to extremes, like today’s near-record high valuations. Consequently, investor behavior moves through stages that range from extreme fear to outright greed/euphoria. We see Euphoria today in investor sentiment surveys, valuations, and the concentration of so much capital into so few stocks. 

As Druckenmiller wisely said, “Most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.” Earnings grow over long periods of time, and investors buy today to earn that future earnings growth.  

The problem is that sometimes, overly optimistic investors bid prices too high relative to the reasonable potential for future earnings. Liquidity enabled all that buying. When liquidity in the system turns, the exit of liquidity will move markets the opposite way. 

This takes us to the story of the Yen Carry Trade, which Felix discussed at length. Japan has become a significant source provider of global liquidity. Who wouldn’t want to borrow money at 0% and invest it in something paying a higher yield? The unwinding of the yen carry trade is way up on the ‘what could go wrong list’. Many believe, as do I, that we are in the early innings of this unwind. This is important! Understanding the complexities of the yen carry trade demonstrates its enormous impact on global liquidity.

Here’s a brief explanation of The Yen Carry Trade: 

The yen carry trade involves borrowing in the Japanese yen, where interest rates are traditionally low, then investing that money in assets or currencies that offer higher returns. Here’s how it works: 

  • Borrowing: An investor borrows yen at a low interest rate from Japan. Generally, they hedge the currency risk (dollar vs. yen, etc.) and invest the borrowed money to earn a higher return. For example, they borrow at 0% and invest in a 10-year Treasury yielding 4.25%. The investor earns the spread, less the currency hedging costs.   
  • Investing: You can convert the yen to another currency with higher interest rates or invest in higher-yielding assets elsewhere, such as bonds, stocks, or currencies from countries like the U.S., Australia, or emerging markets. 

Impact on Liquidity: 

  • When the Yen Weakens, global liquidity increases. Investors can borrow more yen cheaply, leading to more money flowing into international markets, thus creating more liquidity. This can fuel asset price inflation as more cash chases the same pool of investments.  
  • When the Yen Strengthens, global liquidity decreases. If the yen appreciates (perhaps due to higher interest rates in Japan, global risk aversion, or policy shifts), the carry trade becomes less attractive. Investors might sell off their high-yielding investments to pay back yen loans, which may lead to a withdrawal of funds from global markets, reducing liquidity. This can cause asset prices to fall or become more volatile.
  • In essence, movements in the yen relative to other currencies can act like a global liquidity tap, turning on to flood markets with money or turning off to tighten available funds. This can influence everything from stock markets to commodity prices and even real estate in different parts of the world. 

In July 2024, as the BOJ raised interest rates for the first time in 17 years from 0% to 0.25%, the Japanese yen experienced a rapid appreciation, which had significant implications for global markets. The yen’s appreciation was primarily driven by the Bank of Japan’s (BOJ) decision to raise its key interest rate to 0.25% on July 31, 2024, up from 0%. The move was intended to curb the yen’s sharp decline against the U.S. dollar.

Given Japan’s reliance on imports like oil and food, the ultra-low price in the yen meant their cost to buy oil and food became much more expensive since they import both. The inflationary price pressure on Japanese citizens was becoming an concern (and that concern remains today). To address the yen’s depreciation and rising inflation, the Bank of Japan increased its key interest rate.  This policy shift aimed to strengthen the yen and stabilize their economy. However, as we can infer from our short story of ancient markets, there were consequences.  

Indeed, the global web of interconnectivity is complex and risky. The BOJ’s July rate hike was necessary to combat inflation and stabilize the yen. However, the markets didn’t like it, so the BOJ retracted some of its comments. For now, anyway.

This is not a one-and-done thing. It concerns leverage in the system, instability, and a gigantic bubble that still needs to be popped.   

Grab that coffee and find your favorite chair; this week’s post is a good one. I hope I’ve done a good job teeing Felix up.  Felix shares his outlook and advice on what to watch (trend indicators and more) and how to approach the period ahead. You’ll find my summary notes below and a link to his podcast discussion with Jack Farley.

Views are his and subject to change. I hope you enjoy the podcast as much as I did. 

On My Radar: 

  • The Grand Master, Felix Zulauf
  • Trade Signals: December 11, 2024 Update
  • Personal Note: NYC, Penn State, Christmas, Denver, West Palm and Utah

See Important Disclosures at the bottom of this page. Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.

If you like what you are reading, you can subscribe for free.

 

The Grand Master, Felix Zulauf

Discuss global macro outlook and market predictions with renowned investor Felix Zulauf. Click on the photo to listen on Spotify. My notes, along with Yen/Dollar charts, are below.

Source: Monetary Matters with Jack Farley, Spotify

 

How Felix is thinking about the market:

  • Felix noted his conversation recently with Mario Gabelli, where they discussed the market bubble. “No question this is a bubble.” We are at the highest or second-highest level in the history of the US stock market
  • What’s driving the bubble is liquidity. Liquidity needs to grow all the time.
  • If liquidity stops growing, then the bubble breaks.
  • Liquidity has been massively bullish in the last two years. Felix noted it took him a while to figure it out. Liquidity came from unlocking sterilized money on the Fed’s balance sheet of over $2 trillion that was injected into the system and was the driving force for the markets and the economy. It has partly to do with the functioning of the reverse repo market. About $600 billion remains, and he feels it will not get into the system. That source of liquidity is virtually spent.
  • Then, there is ~ $800 billion in the Treasury’s general account (TGA) that could be spent and injected into the system. Still, Felix believes the new incoming Treasury Secretary will unlikely use it. Instead, he will save it for a time of need.
  • Therefore, we are coming to the very end of the liquidy injection into the U.S. stock market. 
  • He doesn’t believe the world economy is in good shape. Many are painting a rosy picture; he doesn’t see it that way.
  • Expect a 1000+ point S&P 500 correction in Q1/Q2 2025, beginning in a few weeks, followed by a potential rally depending on the central bank rescue response.
  • Bearish medium-term on bonds, commodities, and crypto; cautious on China (deflation and won’t bail out aggressively as the West had done), Europe is a mess.

U.S. Stock Market Bubble

  • Currently at highest or second-highest valuation in 140 years (U.S.).
  • Liquidity has been a key driver, but sources like reverse repos ($2T to $600B) are drying up.
  • Expects a 1000+ point S&P 500 correction in Q1/Q2 2025 (to ~5000).
  • Possible rally after correction if Fed eases, potentially to 7000-7500 later in 2025.
  • Volatility will increase significantly; a “decade of roller coasters” is ahead.
  • Timing is tough. Bubbles can go on for longer than we might think.
  • Trigger likely associated with the yen carry trade.
  • He also sees a bubble in the private credit and private debt markets.

Global Liquidity and Yen Carry Trade

  • Global liquidity is drying up, especially from the unwinding yen carry trade.
  • The yen weakening from 80 to 160 vs. the USD provided a primary source of global liquidity.
  • Potential yen strengthening could unwind carry trades, tightening global liquidity.
  • U.S. and Japanese interests align in wanting a stronger yen.
  • Yen strengthening is likely to push up global bond yields and tighten liquidity.

U.S. Dollar and Currencies

  • Capital flowing to the U.S. due to economic/geopolitical factors and the AI narrative.
  • The dollar index could rise from 107 to 110 in the short term.
  • Medium-term dollar top forming; correction possible in the second half of 2025.
  • Europe is facing structural issues; the euro is unlikely to strengthen significantly.

Federal Reserve and Monetary Policy

  • Felix is concerned about the Fed cutting rates despite the relatively strong U.S. economy and persistent inflationary pressures.
  • Criticism of recent Fed chairs as “short-term operators” vs. Volcker’s long-term focus
  • Real inflation likely higher than official figures; deep-rooted U.S. inflation problem

Global Economic Concerns

  • Europe faces a “major economic calamity”: structural issues, uncompetitive energy costs, and a flawed Euro currency experiment.
  • China is in a “deflationary trap,” and the real estate bubble will take 10-20 years to resolve. This is worse than what happened in Japan when It entered its deflationary trap in 1990.
  • U.S. manufacturing is in a recession-like environment despite overall strength.
  • The U.S. employment issue is interesting, as there are more jobs than available labor for the first time in U.S. history.

Trump Administration Market Impact

  • Proposed tariffs could be inflationary, potentially damaging to global trade. He noted the Smoot Hawley Tariff Act in 1930.
  • Felix is unsure if Trump is threatening for bargaining reasons, but if not, it is not good.
  • If Trump initiates half of the intended tariffs, it will be equivalent to the period before WWII 1929 – WWII, which was an economic catastrophe and likely led to war.
  • Potential for a trade war of massive proportions.
  • He expects these announcements in the first six months of the presidential term and believes the markets will be rough.
  • Pro-growth policies like flat taxes are favorable economically, but he noted we are in a different debt situation vs. the Reagan era.
  • Attempts to cut government waste may face bureaucratic challenges.

Commodities Outlook

  • Generally bearish in the next 6 months due to the weak global economy (ex-U.S.).
  • Oil could fall to the low $60s before the potential geopolitical spike. 
  • Gold correction to ~$2400 over next 4 months; long-term bull market intact.
  • Agricultural commodities are bottoming; upside potential from geopolitical disruptions.

Crypto and Bitcoin

  • Correlating to liquidity, expect 50-80% correction when liquidity tightens.
  • Potential short-term run to $115-120k before a major correction.
  • The record inflows into Bitcoin in the last few weeks are another sign of what you see at market tops, not bottoms (referring to both Bitcoin and stock markets). 

Key Next Steps

  • Watch the yen strengthening as the key indicator for global liquidity is beginning to dry up.
  • Monitor technical indicators for potential stock market reversal in the coming weeks. He uses moving averages, trend analysis, put call ratios, and investor sentiment surveys to gauge investor sentiment. 
  • Prepare for increased market volatility throughout 2025.
  • Reassess longer-term outlook after potential Q2 2025 market low.

Felix spoke about his proprietary trend indicator. He favors an intermediate trend (weekly data) process using a short-term moving average compared to a longer one-term moving average. I’ve found it somewhat similar to the Weekly MACD data I share in the next chart; however, his signal is a little quicker. Red arrows in the lower section signal a falling yen vs. the dollar. Green arrows signal a rising yen vs. the dollar. You can see the July yen spike from the green circle to the red circle. Again, the green circle is when the BOJ rose rates to promote a stronger yen. Felix uses a similar process to get a feel for the markets; he also analyzes trends in various markets similarly and uses his trend indicators to assist him in trading. 

Chart 1: Weekly MACD – Japanese Yen to US Dollar

Note – the decline in the price of the yen over the last eight years. I’ve circled the July 2024 low price in green. That’s when the BOJ raised rates and sent a strong “we are going to fight inflation” signal to the market. The red circle is when the back peddled after the concerns due to the shock they sent into global markets. The orange circle shows the price momentum, and the trend is starting to turn up. As I mentioned, the Japanese want a higher yen; the U.S. wants a higher yen, as do many other countries. 

I’ll add this chart to the weekly Trade Signals letter for subscribers. Everyone can create it independently by subscribing to StockCharts.com or other charting services. You can also google (ChatGPT or Grok) to learn how the MACD indicator signal works. It’s not perfect, but as you can see by the signals, it does a good job of identifying the major intermediate-term trend. 

Source: StockCharts.com, CMG Investment Research (Trade Signals)

Chart 2: Monthly MACD – Japanese Yen to US Dollar

A quick note: Felix uses the monthly trend data to get a feel for the dominant trend but uses the weekly trend data for his trading. Here, the monthly yen trend is up (green arrow bottom right in the chart).

 

Source: StockCharts.com, CMG Investment Research (Trade Signals)

 

Please note that I’ve done my best to summarize Felix’s podcast discussion. I can not guarantee accuracy, nor are the views a recommendation to buy or sell any security. His views are subject to change at any time.

Finally, if you are interested in subscribing to Felix’s Research letter, reach out to my friend Jennifer Mendel at jennifer@bluefoxadvisors.com. 

Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.

Trade Signals: December 11, 2024 Update

Market Commentary:

Felix talked about the overvalued U.S. equity market. I am sharing two charts with you that evidence this.

If you are a regular OMR reader or Trade Signals subscriber, you know there is nothing new here.

Bottom line: The market remains hugely overpriced!

Chart 1: Dividend Yields just 9 bps for record low.

Chart 2: Deviation from Long-term trend. Red is bad (arrows), green is good. 

Important: The views expressed herein are solely those of Steve Blumenthal as of the date of this report and are subject to change without notice. Not a recommendation to buy or sell any security.

If you are not a subscriber and would like a free sample, reply to this email, and we’ll send you this week’s post.

Trade Signals is designed for traders and investors seeking a better understanding of technical trends in various markets. Click on the link below to subscribe or login. The letter is free for CMG clients; reply to this email or contact your CMG rep.

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The views expressed herein are solely those of Steve Blumenthal as of the date of this report and are subject to change without notice. Not a recommendation to buy or sell any security.

Personal Note: NYC, Penn State, Christmas, Denver, West Palm and Utah

“Fight on state, fight on state, roar Lions roar.“

I was absolutely glued to the TV last Saturday for the Penn State vs. Oregon game. What a game it was! Four first-half personal fouls and a painful interception put my Nittany Lions in a tough spot early. I’ll admit, Oregon was the better team that day—but just barely.

Fast-forward to Monday, when the selection committee unveiled the top twelve teams and their brackets. The conference winners earned first-round byes, and Oregon’s win over PSU secured them the #1 seed. Meanwhile, Penn State landed the #6 seed.

That said, I think Penn State got a pretty favorable draw. They’ll face SMU at home on December 21st and, if they win, head to Boise State on the 28th. A victory there would set up a showdown against Georgia, Notre Dame, or Indiana for a spot in the final four.

On the other side of the bracket, the Texas vs. Ohio State clash winner will take on Oregon. That’s a much more challenging road, in my opinion. I apologize if you are an SMU or Boise State; I like my Nittany Lion’s chances.

Source: NCAA

Next Tuesday evening, I’ll be in New York City to honor the late, great Art Cashin with some old friends. It will be an evening of thoughtful conversation with a fantastic group of economic deep thinkers: John Mauldin, Barry Habib, Peter Boockvar, Danielle DiMartino Booth, and Ben Hunt. I’m really looking forward to it.

If the weather holds, I’ll be in Happy Valley for the PSU–SMU playoff game on December 21st. It’s an exciting time of year for football fans, and I’m thrilled about the new playoff format—best of luck to your favorite team!

Five of our six are coming home for the holidays, and Susan and I are way behind on shopping. We’ll be braving the crowds this weekend—ugh. But I sure do love it when the whole family is together.

In early January, I’ll head to Denver from the 2nd to the 5th for some business and to squeeze in a few ski days with my son Matthew. We’re planning to hit A-Basin and Winter Park. Then, on January 8th, we’re organizing a client dinner event in West Palm Beach, Florida.

In February, plans are shaping up for skiing in Utah—Park City and Snowbird are calling. There’s snow in them, there hills!

I hope this note finds you with fun plans for your immediate future. 

Keep smiling… Ever forward! 

Steve

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Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Private Wealth Client Website – www.cmgprivatewealth.com
TAMP Advisor Client Webiste – www.cmgwealth.com

Forbes Book – On My Radar, Navigating Stock Market Cycles.  Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth. You can learn more here.

Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.

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This document is prepared by CMG Capital Management Group, Inc. (“CMG”) and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives, or tolerances of any of the recipients. Additionally, CMG’s actual investment positions may, and often will, vary from its conclusions discussed herein based on any number of factors, such as client investment restrictions, portfolio rebalancing, and transaction costs, among others. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This material is for informational and educational purposes only and is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. This material does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors which are necessary considerations before making any investment decision. Investors should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, where appropriate, seek professional advice, including legal, tax, accounting, investment, or other advice. The views expressed herein are solely those of Steve Blumenthal as of the date of this report and are subject to change without notice. 

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