Bitcoin, the barometer of global liquidity

Author: Sam Callahan

Compiled by: Luffy, Foresight News

Abstract

• For any given 12-month period, Bitcoin's direction aligns with global liquidity 83% of the time, a rate higher than any other major asset class, making Bitcoin a barometer of liquidity.
• Bitcoin has a high correlation with global liquidity but is not immune to short-term deviations caused by specific events or internal market dynamics.
• Combining the state of global liquidity with on-chain valuation metrics for Bitcoin can provide a more nuanced understanding of Bitcoin cycles, helping investors identify situations where internal market dynamics may decouple Bitcoin from global liquidity trends.

Correlation of Major Asset Classes with Global Liquidity

Background

For investors looking to enhance returns and effectively manage risk, understanding how asset prices change with fluctuations in global liquidity has become crucial. In today's market, asset prices are increasingly influenced by central bank policies that directly affect liquidity conditions. Fundamentals are no longer the primary drivers of asset prices.

This phenomenon has become more pronounced since the global financial crisis. Since then, these unconventional monetary policies have increasingly become the dominant force driving asset prices. Central bank leaders have leveraged liquidity to turn markets into a grand trade, as economist Mohamed El-Erian puts it, central banks have become "the only game in town."

Stanley Druckenmiller has expressed a similar sentiment, stating, "Earnings don't move the entire market; it's the Fed that moves the market… Focus on the central banks and the flow of liquidity… Most people in the market are focused on earnings and conventional metrics. Liquidity is what drives the market."

This is particularly evident in the S&P 500 index.

Comparison of the S&P 500 Index and Global M2 Trends

The correlation shown in the above chart can be summarized by a simple supply and demand relationship. If more money is available to purchase something, whether it be stocks, bonds, gold, or Bitcoin, the prices of these assets typically rise. Since 2008, central banks have injected more fiat currency into the financial system, and asset prices have responded accordingly. In other words, monetary inflation has fueled asset price inflation.

In this context, investors must understand how to measure global liquidity and how different assets respond to changes in liquidity conditions to better navigate these liquidity-driven markets.

How to Measure Global Liquidity

There are many ways to measure global liquidity; in this report, we will use global M2: a broad measure of the money supply that includes physical currency, checking accounts, savings deposits, money market securities, and other forms of easily accessible cash.

Bitcoin Magazine Pro provides a measure of global M2 that aggregates data from the eight largest economies: the United States, China, the Eurozone, the United Kingdom, Japan, Canada, Russia, and Australia. It serves as a good indicator of global liquidity because it reflects the total amount of funds available for spending, investing, and borrowing worldwide. Another way to think about it is as a measure of the total amount of credit creation and central bank money printing in the global economy.

One subtlety here is that global M2 is denominated in U.S. dollars. Lyn Alden explained in a previous article why this is important:

The dollar's denomination is significant because the dollar is the global reserve currency and the primary unit of account for global trade, contracts, and debt. When the dollar strengthens, debts in other countries become harder. When the dollar weakens, debts in other countries become easier. The dollar-denominated global broad money supply serves as an important indicator of global liquidity. It reflects how quickly fiat currency units are being created and how strong the dollar is relative to other global currency markets.

When global M2 is denominated in dollars, it reflects both the relative strength of the dollar and the speed of credit creation, making it a reliable indicator of the state of global liquidity.

Why Bitcoin May Be the Purest Barometer of Liquidity

For years, one asset has shown a strong correlation with global liquidity: Bitcoin. As global liquidity expands, Bitcoin tends to thrive. Conversely, when liquidity contracts, Bitcoin is also affected. This phenomenon has led some to refer to Bitcoin as a "liquidity barometer."

The chart below clearly shows how Bitcoin's price tracks changes in global liquidity.

Similarly, comparing the year-on-year percentage changes of Bitcoin and global liquidity highlights the synchronicity of their movements; when liquidity increases, Bitcoin's price rises, and when liquidity decreases, Bitcoin's price falls.

From the above chart, it is evident that Bitcoin's price is highly sensitive to changes in global liquidity. But is it the most sensitive asset in today's market?

Generally, risk assets have a higher correlation with liquidity conditions. In a more liquid environment, investors tend to adopt risk-seeking strategies, shifting capital into higher-risk/higher-return assets. Conversely, when liquidity tightens, investors typically move capital into what they perceive as safer assets. This explains why assets like stocks often perform well in environments of increasing liquidity.

However, stock prices are also influenced by other factors beyond liquidity conditions. For example, stock performance is partially driven by earnings and dividends, which may weaken the correlation between stocks and global liquidity.

Additionally, the U.S. stock market benefits from structural buying through passive inflows from retirement accounts like 401(k)s, which further impacts its performance regardless of liquidity conditions. These passive inflows can buffer the U.S. stock market during fluctuations in liquidity conditions, potentially reducing its sensitivity to global liquidity.

The relationship between gold and liquidity is more complex. On one hand, gold benefits from increased liquidity and a weaker dollar; on the other hand, gold is also viewed as a safe-haven asset. During periods of liquidity contraction and risk aversion, investors seek safety, which may increase demand for gold. This means that even when liquidity weakens, gold prices can still perform well. Therefore, gold's performance may not be as closely tied to liquidity conditions as other assets.

Like gold, bonds are also viewed as safe-haven assets, so their correlation with liquidity conditions may be lower.

Finally, we return to Bitcoin. Unlike stocks, Bitcoin has no earnings or dividends and lacks structural buying that influences its performance. Unlike gold and bonds, at this stage of Bitcoin's adoption cycle, most pools of capital still view it as a risk asset. Relative to other assets, Bitcoin's correlation with global liquidity is the purest.

If this is the case, then it is a valuable conclusion for Bitcoin investors and traders. For long-term holders, understanding Bitcoin's correlation with liquidity can provide deeper insights into the drivers of its price changes over time. For traders, Bitcoin offers a tool to express views on the future direction of global liquidity.

This article aims to delve into the correlation between Bitcoin and global liquidity, compare its relationship with other asset classes, identify periods of correlation breakdown, and share how investors can leverage this information for profit in the future.

Quantifying the Correlation Between Bitcoin and Global Liquidity

When analyzing the correlation between Bitcoin and global liquidity, it is important to consider both the magnitude and direction of the correlation.

The magnitude of the correlation indicates the degree of association between the two variables. A higher correlation suggests that changes in global M2 have a more predictable impact on Bitcoin's price. Understanding this degree of association is key to measuring Bitcoin's sensitivity to changes in global liquidity.

Based on data from May 2013 to July 2024, Bitcoin's strong sensitivity to liquidity is evident. During this period, the correlation between Bitcoin's price and global liquidity is 0.94, reflecting a very strong positive correlation. This indicates that Bitcoin's price is highly sensitive to changes in global liquidity within this time frame.

From a 12-month rolling correlation perspective, the average correlation between Bitcoin and global liquidity drops to 0.51. This still represents a positive correlation but is significantly lower than the overall correlation.

Furthermore, when examining the 6-month rolling correlation, the correlation further declines to 0.36.

This indicates that as the time frame shortens, Bitcoin's price deviates more from its long-term liquidity trend, suggesting that short-term price movements are more likely influenced by internal factors within Bitcoin rather than liquidity conditions.

To better understand the correlation between Bitcoin and global liquidity, we compared it with other assets, including the SPDR S&P 500 ETF (SPX), Vanguard Total World Stock ETF (VT), iShares MSCI Emerging Markets ETF (EEM), iShares 20+ Year Treasury Bond ETF (TLT), Vanguard Total Bond Market ETF (BND), and gold.

In terms of 12-month rolling correlation, Bitcoin ranks highest, followed by gold, then stock indices, while bond indices show the weakest correlation with liquidity.

When analyzing the correlation between assets and global liquidity based on year-on-year percentage changes, stock indices exhibit a slightly stronger correlation than Bitcoin, followed by gold and bonds.

In terms of year-on-year percentage changes, the correlation between stocks and global liquidity may be higher than that of Bitcoin, partly due to Bitcoin's high volatility. Bitcoin's price often experiences significant fluctuations within a year, which may distort its correlation with global liquidity. In contrast, stock indices typically exhibit less pronounced price volatility, aligning more closely with year-on-year percentage changes in global M2. Nevertheless, Bitcoin's correlation with global liquidity remains quite strong when viewed through the lens of year-on-year percentage changes.

The data above highlights three key points: 1) The performance of stocks, gold, and Bitcoin is closely related to global liquidity; 2) Compared to other asset classes, Bitcoin exhibits a strong overall correlation, with the highest correlation in the 12-month rolling period; 3) As the time frame shortens, the correlation between Bitcoin and global liquidity weakens.

Bitcoin's Directional Consistency with Liquidity Sets It Apart

As previously mentioned, a strong positive correlation does not guarantee that two variables will always move in the same direction over time. This is especially true when an asset (like Bitcoin) is highly volatile and may temporarily deviate from its long-term correlation with a less volatile indicator (like global M2). This is why combining these two aspects (magnitude and direction) can provide a more comprehensive understanding of how Bitcoin and global M2 influence each other over time.

By examining the directional consistency of the correlation, we can better understand the reliability of their relationship. This is particularly important for those interested in long-term trends. If you know that Bitcoin tends to track the direction of global liquidity most of the time, you can be more confident in predicting Bitcoin's future price direction based on changes in liquidity conditions. Among all the analyzed assets, Bitcoin has the highest directional correlation with global liquidity.

The chart below further illustrates Bitcoin's directional consistency with global liquidity over a 12-month rolling period compared to other asset classes.

This indicates that while the strength of the correlation may vary with the time frame, Bitcoin's price direction typically aligns with that of global liquidity. Furthermore, its price direction is closer to global liquidity than any other traditional asset analyzed.

The relationship between Bitcoin and global liquidity is strong not only in magnitude but also in directional consistency. The data further supports the notion that Bitcoin is more sensitive to liquidity conditions than other traditional assets, especially over longer time frames.

For investors, this means that global liquidity may be a key driver of Bitcoin's long-term price performance, and this factor should be considered when assessing Bitcoin's market cycles and predicting future price movements. For traders, this means that Bitcoin provides a highly sensitive investment tool to express views on global liquidity, making it a preferred reference for those with strong beliefs about liquidity.

The Flaws of Bitcoin's Correlation with Liquidity

Although Bitcoin generally exhibits a strong correlation with global liquidity, the findings indicate that over shorter rolling periods, Bitcoin's price often deviates from liquidity trends. These deviations may be due to internal market dynamics exerting a greater influence on Bitcoin's market cycle at certain moments than global liquidity conditions, or they may be caused by specific events unique to the Bitcoin industry.

Special events refer to occurrences within the cryptocurrency industry that can lead to rapid shifts in market sentiment or trigger large-scale liquidations. Examples include major corporate bankruptcies, exchange hacks, regulatory crackdowns, or the collapse of Ponzi schemes.

Looking back at periods when the 12-month rolling correlation between Bitcoin and global liquidity weakened, it is clear that Bitcoin's price often decouples from global liquidity trends during significant industry events.

The chart below illustrates the decoupling of Bitcoin's correlation with liquidity during major industry events.

Key events such as the Mt. Gox collapse, the PlusToken Ponzi scheme's downfall, and the Terra/Luna collapse triggered panic and selling pressure that were largely disconnected from global liquidity trends.

The COVID-19 market crash in 2020 is another example. Amid widespread panic selling and risk aversion, Bitcoin initially plummeted. However, as central banks injected unprecedented liquidity as a countermeasure, Bitcoin quickly rebounded, highlighting its sensitivity to changes in liquidity. The decoupling of correlation at that time can be attributed to a sudden shift in market sentiment rather than changes in liquidity conditions.

While understanding the impact of these special events on the correlation between Bitcoin and global liquidity is important, their unpredictability makes it difficult for investors to take action. That said, as the Bitcoin ecosystem matures, infrastructure improves, and regulations become clearer, I expect the frequency of these "black swan" events to decrease over time.

How Supply Side Influences Bitcoin's Liquidity Correlation

In addition to special events, another noteworthy phenomenon during periods of weakened correlation between Bitcoin and liquidity is that these situations often coincide with times when Bitcoin's price reaches extreme valuations and subsequently declines sharply. This is evident during the bull market peaks of 2013, 2017, and 2021, when Bitcoin's correlation with liquidity decoupled as its price fell significantly from highs.

While liquidity primarily affects the demand side of the equation, understanding the distribution patterns on the supply side also helps identify periods when Bitcoin may deviate from its long-term correlation with global liquidity.

The primary source of supply comes from old holders taking profits as Bitcoin's price rises. New issuance from block rewards also contributes to market supply, but the volume is much smaller and continues to decrease with each halving event. During bull markets, old holders typically reduce their positions and sell to new buyers until demand saturates. This saturation moment often marks the peak of the bull market.

A key metric for assessing this behavior is the percentage of Bitcoin held for over a year, which measures the amount of Bitcoin held by long-term holders (at least one year) as a percentage of the total circulating supply. In other words, it gauges the percentage of total available supply held by long-term investors at any given time.

Historically, this metric declines during bull markets as long-term holders sell; during bear markets, long-term holders accumulate, and this metric rises. The chart below illustrates this behavior, with red circles indicating cycle peaks and green circles indicating bottoms.

This illustrates the behavior of long-term holders during Bitcoin cycles. When Bitcoin appears overvalued, long-term holders tend to sell for profit, while when Bitcoin seems undervalued, they tend to accumulate.

The question becomes… "How do you determine when Bitcoin is undervalued or overvalued to better predict when supply will flood the market or be depleted?"

Although the dataset remains relatively small, the Market Value to Realized Value Z-score (MVRV Z-score) has proven to be a reliable tool for identifying when Bitcoin reaches extreme valuation levels. The MVRV Z-score is based on three components:

1) Market Value: The current market cap, calculated by multiplying Bitcoin's price by the total circulating supply of Bitcoin.

2) Realized Value: The average price at which each Bitcoin or UTXO last transacted on-chain, multiplied by the total circulating supply—essentially the cost basis for Bitcoin holders.

3) Z-score: This score measures the deviation of market value from realized value in standard deviations, highlighting periods of extreme overvaluation or undervaluation.

When the MVRV Z-score is high, it indicates a significant gap between market price and realized price, suggesting that many holders are sitting on unrealized profits. This is intuitively a good thing, but it may also indicate that Bitcoin is overbought or overvalued, making it a good time for long-term holders to sell Bitcoin and take profits.

When the MVRV Z-score is low, it means the market price is close to or below the realized price, indicating that Bitcoin is oversold or undervalued, making it a good time for investors to start accumulating.

When the MVRV Z-score is overlaid with the 12-month rolling correlation between Bitcoin and global liquidity, a pattern begins to emerge. When the MVRV Z-score sharply declines from historical highs, the 12-month rolling correlation seems to break down. The red rectangles indicate these time periods.

This suggests that when Bitcoin's MVRV Z-score begins to decline from highs and the correlation with liquidity breaks down, internal market dynamics (such as profit-taking and panic selling) may exert a greater influence on Bitcoin's price than global liquidity conditions.

At extreme valuation levels, Bitcoin's price movements are often more influenced by market sentiment and supply-side dynamics rather than global liquidity trends. This finding is valuable for traders and investors as it helps identify when Bitcoin deviates from its long-term correlation with global liquidity.

For example, suppose a trader firmly believes that the dollar will decline and global liquidity will rise over the next year. Based on this analysis, Bitcoin would be the best tool to validate his viewpoint, as it is the purest liquidity barometer in today's market.

However, traders should first assess Bitcoin's MVRV Z-score or similar valuation metrics before making trades. If Bitcoin's MVRV Z-score indicates overvaluation, traders should exercise caution even in a liquid environment, as internal market dynamics may surpass liquidity conditions and drive price adjustments.

By monitoring the long-term correlation between Bitcoin and global liquidity along with the MVRV Z-score, investors and traders can better predict how Bitcoin's price will respond to changes in liquidity conditions. This approach enables market participants to make more informed decisions and potentially increase their success rates when investing in or trading Bitcoin.

Conclusion

The strong correlation between Bitcoin and global liquidity makes it a macroeconomic barometer for investors and traders. Compared to other asset classes, Bitcoin's correlation with global liquidity is not only strong but also exhibits the highest degree of directional consistency. Bitcoin can be viewed as a mirror reflecting the speed of global money creation and the relative strength of the dollar. Unlike traditional assets such as stocks, gold, or bonds, Bitcoin's correlation with liquidity is the purest.

However, Bitcoin's correlation is not perfect. Research indicates that the strength of Bitcoin's correlation may decrease in the short term, highlighting the importance of identifying periods when the correlation between Bitcoin and liquidity breaks down.

Internal market dynamics within Bitcoin, such as special events or extreme valuation levels, may cause it to temporarily deviate from the influence of global liquidity. These periods are crucial for investors as they often signal price adjustments or accumulation phases. Combining global liquidity analysis with on-chain metrics (such as the MVRV Z-score) can provide better insights into Bitcoin's price cycles and help determine when its price may be driven more by sentiment than by liquidity trends.

Michael Saylor once famously said, "All your models are broken." Bitcoin represents a paradigm shift in money itself. Therefore, no statistical model can perfectly capture the complexity of the Bitcoin phenomenon, but some models can serve as useful tools for guiding decision-making. As the old saying goes, "All models are wrong, but some models are useful."

Since the global financial crisis, central banks have distorted financial markets through unconventional policies, making liquidity the primary driver of asset prices. Therefore, understanding changes in global liquidity is crucial for any investor looking to successfully navigate today's markets. In the past, macro analyst Luke Gromen described Bitcoin as "the last fully functional smoke detector," as it can signal changes in liquidity conditions.

When Bitcoin's alarm sounds, investors should wisely listen to manage risk and strategize to take full advantage of future market opportunities.