Author: Sam Callahan, Lyn Alden Translation: Block unicorn
Summary
- In any given 12-month period, the direction of BTC movement is in line with global Liquidity 83% of the time, a higher rate than any other major asset class, making it a powerful indicator of Liquidity conditions.
- The correlation between BTC and global liquidity is high, but it is not immune to short-term deviations caused by special events or internal market dynamics, especially during periods of extreme valuation.
- Combining the global Liquidity situation with the on-chain valuation indicators of Bitcoin can provide a more detailed understanding of the BTC cycle, helping investors identify the moments when internal market dynamics may temporarily depeg the BTC from the Liquidity trend.
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Introduction
For investors who want to increase returns and manage risks effectively, it has become crucial to understand how asset prices change with the fluctuation of global Liquidity. In today’s market, asset prices are increasingly influenced by Central Bank policies directly affecting Liquidity conditions. Fundamentals are no longer the primary driving factor of asset prices.
Since the global financial crisis (GFC), this has been particularly evident. Since then, these unconventional monetary policies have increasingly become the dominant force driving asset prices. Central Bank governors use Liquidity leverage to turn the market into a big trade, as economist Mohamed El-Erian has said, the Central Bank has become the “only game in town”.
Stanley Druckenmiller also expressed the same view, saying, ‘Profits don’t drive the whole market, it’s the Federal Reserve…follow the central banks and follow the changes in liquidity…most people in the market are looking for profits and conventional indicators. Liquidity is the key driver of the market.’
When we examine how the S&P 500 tracks global liquidity after the GFC, this becomes particularly evident.
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The explanation of the above chart boils down to a simple supply and demand relationship. If there is more money available to buy something, whether it’s stocks, bonds, gold, or BTC, the prices of these assets usually pump. Since 2008, Central Banks around the world have injected more fiat currency into the financial system, and asset prices have responded accordingly. In other words, monetary inflation fuels asset price inflation.
Against this background, investors must understand how to measure global Liquidity and how different assets react to changes in Liquidity conditions, becoming crucial in order to better navigate these Liquidity-driven markets.
How to Measure Global Liquidity
There are many ways to measure Liquidity globally, but in this analysis, we will use global M2 - a broad Money Supply measure that includes physical currency, demand deposits, savings deposits, money market securities, and other forms of easily accessible cash.
Bitcoin Magazine Pro provides a global M2 measure that aggregates data from the eight largest economies: the United States, China, the Eurozone, the United Kingdom, Japan, Canada, Russia, and Australia. It is a good indicator of global liquidity, as it can reflect the total amount of funds available for consumption, investment, and borrowing worldwide. Another way to understand it is as a measure of the total credit creation and central bank money printing in the global economy.
One subtle difference here is that global M2 is priced in US dollars. Lyn Alden explained in a previous article why this is important:
The reason why the dollar pricing is important is that the dollar is the global reserve currency, so it is the main accounting unit for global trade, global contracts, and global debt. When the dollar strengthens, the debt of various countries will become harder. When the dollar weakens, the debt of various countries will become softer. The globally priced Broad Money in dollars is like an important indicator of measuring global liquidity. How fast is the creation speed of the legal currency unit? How strong is the dollar relative to other currency markets around the world?
When global M2 is denominated in US dollars, it reflects both the relative strength of the US dollar and the speed of credit creation, making it a reliable indicator of global liquidity.
Why BTC may be the purest Liquidity indicator
For many years, there has been a strong correlation between a certain asset and global Liquidity, and that is BTC. As global Liquidity expands, BTC often thrives. Conversely, when Liquidity contracts, BTC tends to be affected. This dynamic has led some to refer to BTC as a “Liquidity barometer”.
The following diagram clearly shows how the price of BTC tracks the changes in global Liquidity.
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Similarly, comparing the year-on-year percentage changes of BTC and global Liquidity also highlights the seemingly synchronous movements of the two. When Liquidity increases, the price of BTC pumps, and when Liquidity decreases, the price of BTC falls.
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From the above figure, it can be seen that the price of Bitcoin seems to be highly sensitive to the changes in global Liquidity. But is it the most sensitive asset in today’s market?
In general, the correlation between risk assets and Liquidity conditions is higher. In a good Liquidity environment, investors tend to adopt a risk preference strategy and transfer capital to assets considered high risk and high return. Conversely, when Liquidity tightens, investors usually shift capital to assets they consider safer. This explains why in a Liquidityrise environment, stocks and other assets typically perform well.
However, stock prices are also influenced by other unrelated factors, such as profitability and Dividend, which are not related to Liquidity conditions. For example, the performance of stocks is partly driven by factors such as earnings and Dividend, so their prices are also linked to economic performance. This may have a negative impact on the pure correlation between stock prices and global Liquidity.
In addition, the US stock market also benefits from passive inflows from retirement accounts such as 401(k), which further affects its performance, regardless of Liquidity conditions. These passive fund inflows may buffer the US stock market during Liquidity Fluctuation, potentially reducing its sensitivity to global Liquidity conditions.
The relationship between gold and Liquidity is even more complex. On the one hand, gold benefits from Liquidity rise and a weak dollar, but on the other hand, gold is also seen as a safe-haven asset. In periods of Liquidity contraction and risk aversion, investors seek safety, and the demand for gold may increase. This means that even if Liquidity is lost from the system, the price of gold can still remain strong. Therefore, the performance of gold may not be as closely related to Liquidity conditions as other assets.
Like gold, bonds are also considered safe-haven assets, so their correlation with Liquidity may be lower.
This brings us back to BTC. Unlike stocks, BTC has no earnings or Dividend, and there is no structural buying that affects its performance. Unlike gold and bonds, at this stage of the BTC cycle, most capital pools still view it as a risk asset. This makes BTC potentially have the most pure correlation with global Liquidity compared to other assets.
If this is true, it would be a valuable insight for BTC investors and traders. For long-term holders, understanding the correlation between BTC and Liquidity can provide a deeper understanding of the driving factors behind its price changes over time. For traders, BTC provides a tool to express their views on the future direction of global Liquidity.
This article aims to delve into the correlation between BTC and global Liquidity, compare its relationship with other asset classes, identify periods of correlation failure, and share insights on how investors can use this information to their advantage in the future.
The correlation between quantified BTC and global liquidity
When analyzing the correlation between Bitcoin and global Liquidity, it is important to consider the strength and direction of the relationship.
The strength of correlation reveals the degree of correlation between two variables. The higher the correlation, the more predictable the impact of global M2 changes on BTC prices, whether in the same direction or in reverse. Understanding this correlation is key to measuring BTC’s sensitivity to global liquidity changes.
When analyzing the data between May 2013 and July 2024, it is obvious that BTC is highly sensitive to Liquidity. During this period, the correlation between BTC price and global Liquidity is 0.94, reflecting a very strong positive correlation. This indicates that the price of BTC is highly sensitive to changes in global Liquidity during this time frame.
From the 12-month rolling correlation, the average correlation between BTC and global Liquidity has dropped to 0.51. This is still a moderately positive relationship, but significantly lower than the overall correlation.
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This indicates that the annual change in the price of Bitcoin is not so closely related to Liquidity. In addition, when examining the 6-month rolling correlation, the correlation further dropped to 0.36.
This suggests that as the time frame shortens, the deviation between the price of BTC and its long-term Liquidity trend becomes greater, implying that short-term price action is more likely to be influenced by specific BTC factors rather than Liquidity conditions.
To better understand the correlation between BTC and global Liquidity, we compared it with other assets including SPDR S&P 500 ETF (SPX), Vanguard Total Stock Market ETF (VT), iShares MSCI Emerging Markets ETF (EEM), iShares 20+ Year Treasury Bond ETF (TLT), Vanguard Total Bond Market ETF (BND) and gold.
Over the 12-month period, BTC has the highest average correlation with global Liquidity, followed closely by gold. Stock index correlation follows, and as expected, bond index has the lowest correlation with Liquidity.
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When analyzing the correlation of assets with global Liquidity in terms of year-on-year percentage changes, stock indices show a slightly stronger correlation than Bitcoin, followed by gold and bonds.
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From a year-over-year percentage perspective, the correlation between stocks and global Liquidity may be higher than that of Bitcoin, partly because Bitcoin has significant Fluctuation. The price of Bitcoin usually experiences significant Fluctuation within a year, which may distort its correlation with global Liquidity. In contrast, the price Fluctuation of stock indices is usually less obvious, and closer to the year-over-year percentage change of global M2. Nevertheless, from the perspective of year-over-year percentage change, the correlation between Bitcoin and global Liquidity remains quite strong.
The above data emphasizes three key points: 1) The performance of stocks, gold, and Bitcoin is closely related to global liquidity; 2) Compared to other asset classes, Bitcoin has 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.
BTC and Liquidity’s direction makes it unique
As we mentioned before, strong correlation does not guarantee that two variables always move in the same direction over time. This is especially true when an asset (such as BTC) has high volatility and may temporarily deviate from the long-term relationship with a less volatile indicator (such as global M2). That’s why combining both aspects - strength and direction - can provide a more comprehensive understanding of the interaction between BTC and global M2.
By examining the direction consistency of this relationship, we can better understand the reliability of their correlation. This is particularly important for those interested in long-term trends. If you know that BTC tends to follow the direction of global liquidity most of the time, you can be more confident in predicting its future price direction based on changes in liquidity conditions.
In terms of directional consistency, BTC has the highest correlation with global liquidity among all analyzed assets. In the 12-month period, the proportion of BTC moving in the same direction as global liquidity is 83%, and in the 6-month period, it is 74%, highlighting the consistency of the directional relationship.
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The chart below further illustrates BTC’s directional consistency with global liquidity compared to other asset classes within the past 12 months.
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These findings are worth noting because they indicate that, although the strength of correlation may vary over time ranges, the price trend of Bitcoin usually aligns with the direction of global Liquidity. Additionally, its price trend is closer to global Liquidity than any other traditional asset analyzed.
This analysis shows that the relationship between BTC and global Liquidity is not only strong in scale, but also consistent in direction. The data further confirms the view that BTC is more sensitive to Liquidity conditions than other traditional assets, especially over a longer time frame.
For investors, this means that global Liquidity may be a key driving factor for long-term price performance of BTC, and this factor should be considered when evaluating BTC market cycles and predicting future PA. For traders, this means that BTC offers a highly sensitive investment vehicles to express their views on global Liquidity, making it the preferred choice for investors who have a strong belief in Liquidity.
Identifying the breakthrough point of long-term Liquidity relationship in BTC
Although Bitcoin has a strong correlation with global Liquidity overall, research results show that in shorter rolling periods, the price of Bitcoin often deviates from the trend of Liquidity. These deviations may be caused by internal market dynamics having a greater impact on the Bitcoin market cycle at certain times than global Liquidity conditions, or driven by idiosyncratic events specific to the Bitcoin industry.
An occasional incident refers to events that occur within the Cryptocurrency industry, which can lead to rapid changes in market sentiment or trigger large-scale liquidation. For example, events such as the bankruptcy of large enterprises, exchange Hacker attacks, regulatory dynamics, or the collapse of Ponzi Schemes.
Looking back at historical instances of BTC’s 12-month rolling correlation with global Liquidity, it is clear that BTC’s price often depegs from Liquidity trends during major industry events.
The graph below shows how the correlation between BTC and Liquidity collapsed around these major events.
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The panic and dumping pressure caused by key events such as the Mt. Gox collapse, the PlusToken Ponzi Scheme’s collapse, as well as the Cryptocurrency credit crisis caused by the collapse of Terra/Luna and several Cryptocurrency lending institutions bankruptcies, are basically disconnected from the global Liquidity trend.
The COVID-19 market crash in 2020 provided another example. In the widespread panic dumping and risk aversion, BTC initially plummeted. However, as Central Banks around the world took unprecedented Liquidity injections in response, BTC quickly Rebound, highlighting its sensitivity to Liquidity changes. The collapse of correlation at that time can be attributed to the sudden shift in market sentiment, rather than changes in Liquidity conditions.
While understanding the impact of these occasional events on Bitcoin and the global Liquiditycorrelation is important, their unpredictability makes it difficult for investors to take action. That being said, as the BTC ecosystem matures, infrastructure improves, and regulations become clearer, I expect the frequency of these ‘black swan’ events to decrease over time.
How does the supply side dynamics affect Bitcoin’s Liquiditycorrelation
In addition to isolated incidents, another noteworthy pattern is that periods of reduced correlation between BTC and Liquidity typically coincide with extreme overvaluation of BTC followed by sharp declines. This was evident at the peaks of the Bull Markets in 2013, 2017, and 2021, when the correlation between BTC and Liquidity depegged sharply as its price dropped significantly from the highs.
Although Liquidity primarily affects the demand side of the equation, understanding the distribution pattern of the supply side also helps identify periods when BTC may deviate from its long-term correlation with global Liquidity.
The main source of supply comes from old holders who profit as the BTC price pumps. The new issuance of Block Reward will also increase market supply, but the supply will be much less, and will continue to decrease with each Halving event. During the Bull Market, old holders usually reduce their positions and sell to new buyers until demand is saturated. At this saturation point, the peak of the Bull Market usually appears.
One key metric to assess this behavior is the HODL wave of BTC for over 1 year, which measures the percentage of BTC held by long-term holders (at least one year) in the total circulating supply. Essentially, it measures the percentage of total available supply held by long-term investors at any given point in time.
Historically, this indicator tends to decline during bull markets as long-term holders start dumping; during bear markets, long-term holders increase their holdings, causing this indicator to rise. The chart below highlights this behavior, with red circles representing market peaks and green circles representing bottoms.
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This explains the behavior of long-term holders in the BTC cycle. When BTC appears to be overvalued, long-term holders often profit, and when BTC appears to be undervalued, they often increase their holdings.
Now the question becomes… ‘How do you determine when BTC is undervalued or overvalued, in order to better predict when the supply will flood the market or be exhausted from the market?’
Although the dataset is still relatively small, the market value versus realized value Z-score (MVRV Z-score) has been proven to be a reliable tool for identifying when BTC reaches extreme valuation levels. The MVRV Z-score is based on three components:
1.) Market Value - The current Market Cap is calculated by multiplying the price of BTC by the total number of BTC in circulation.
2.) Realizing value—the average cost of each BTC or Unspent Transaction Output (UTXO) at the time of on-chain transaction, multiplied by the total circulating supply—essentially the on-chain cost basis of Bitcoin holders.
3.) Z-score - Measures the deviation between market value and intrinsic value, expressed in standard deviations, highlighting periods of extreme overvaluation or undervaluation.
When the MVRV Z-Score is high, it means there is a significant gap between the market price and the realized price, indicating that many holders are sitting on unrealized profits. This is generally a positive thing, but it may also indicate that BTC is overbought or overvalued, which presents a good opportunity for long-term holders to sell BTC and make a profit.
When the MVRV Z-Score is low, it means that the market price is close to or below the actual price, indicating that BTC is Oversold or undervalued - this is a good time for investors to start accumulating.
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A pattern begins to emerge when the MVRV Z-Score overlaps with the 12-month rolling correlation between BTC and global Liquidity. When the MVRV Z-Score drops sharply from its historical highs, the 12-month rolling correlation appears to break down. The red rectangular box below highlights these periods.
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This suggests that when BTC’s MVRV Z-Score begins to decline from a high level and the correlation with Liquidity breaks down, internal market dynamics (such as profit-taking and panic dumping) may have a greater impact on BTC price than the global Liquidity condition.
At extreme valuation levels, BTC’s price action is often driven more by market sentiment and supply-side dynamics than global liquidity trends. This insight is valuable for traders and investors as it can help identify rare situations where BTC deviates from its long-term correlation with global liquidity.
For example, suppose a trader is convinced that the US dollar will fall, while global Liquidity will rise in the coming year. Based on this analysis, Bitcoin will be the best tool to express his views, as it is the purest barometer of Liquidity in today’s market.
However, these findings suggest that traders should first assess the MVRV Z-Score or similar valuation indicators of BTC before trading. If the MVRV Z-Score of BTC indicates overvaluation, traders should exercise caution even in a environment with good liquidity, as internal market dynamics may surpass liquidity conditions and drive price adjustments.
By monitoring the long-term correlation of BTC with global Liquidity and its MVRV Z-Score, investors and traders can better predict how BTC prices will respond to changes in Liquidity conditions. This approach enables market participants to make wiser decisions and may increase their chances of successful outcomes when investing or trading BTC.
Conclusion
Bitcoin’s strong correlation with global Liquidity makes it a valuable macroeconomic indicator for investors and traders. Compared to other asset classes, BTC not only has a strong correlation, but also the highest degree of consistency with the direction of global Liquidity. People can regard BTC as a mirror reflecting the global currency creation speed and the relative strength of the US dollar. Unlike traditional assets such as stocks, gold, or bonds, BTC’s correlation with Liquidity remains relatively pure.
However, the correlation of Bitcoin is not perfect. These findings suggest that the strength of Bitcoin’s correlation decreases over shorter periods of time, and also indicate the importance of identifying periods when the correlation between Bitcoin and Liquidity is prone to breaking.
Internal market dynamics, such as incidental events or extreme valuation levels, may cause BTC to temporarily deviate from global Liquidity conditions. These times are critical for investors as they often signal price adjustments or accumulation periods. Combining global Liquidity analysis with on-chain indicators (such as MVRV Z-Score) can provide a better understanding of BTC’s price cycles and help determine when its price may be more driven by sentiment rather than broader global Liquidity trends.
Michael Saylor once said, “All of your models are destroyed.” BTC represents a paradigm shift in the nature of currency. Therefore, no statistical model can perfectly capture the complexity of the BTC phenomenon, but some models can serve as useful tools for decision-making, even if they are imperfect. As the old saying goes, “All models are wrong, but some models are useful.”
Since the global financial crisis, Central Banks around the world have distorted the financial markets through unconventional policies, making Liquidity a major driving factor of asset prices. Therefore, understanding the changes in global Liquidity is crucial for any investor looking to successfully navigate the markets today. In the past, macro analyst Luke Gromen has described BTC as the ‘last fully functioning smoke alarm’ because it can signal changes in Liquidity conditions, and this analysis supports that statement.
When the Bitcoin alarm sounds, investors should listen wisely to manage risks and position themselves appropriately to seize future market opportunities.
Appendix
One interesting finding of this analysis is that, compared to the S&P 500 index, international stock ETFs such as EEM and VT have weaker correlations with global Liquidity. Traditionally, investors express their views on global Liquidity through emerging market stocks. There are many reasons for this situation:
1.) Emerging market stocks are generally considered to be more risky than developed market stocks. Therefore, it is widely believed that they are more sensitive to changes in global Liquidity.
2.) Emerging market stocks do not have the structural buying pressure of retirement accounts like US stocks, which may distort their relationship with global liquidity.
3.) Emerging markets are heavily reliant on foreign financing. According to the data from the Bank for International Settlements, emerging market economies currently hold trillions of US dollars in dollar-denominated debt. This makes them more sensitive to changes in global liquidity, as the cost of servicing their dollar-denominated debt increases when liquidity tightens and the US dollar strengthens. In addition to the increased cost of servicing their debt, their future borrowing costs will also be higher.
During the analysis of these correlations, the US dollar was in a strong dollar cycle, which put pressure on emerging market economies and affected the entire data set.
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Therefore, over the past decade, the performance of the S&P 500 has outperformed EEM, reflecting the challenges faced by emerging markets in a strong dollar environment.
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By comparing the two charts side by side, it is clear that there have been multiple divergences in the price movements of SPY and EEM during this time period, with SPY pumping while EEM has experienced a decline or sideways movement.
The chart below highlights the divergence between SPY and EEM at different points in time, showing that when SPY pumps, EEM either falls or goes Sideways.
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This divergence explains why the correlation between EEM and global liquidity may not be as strong as expected during this period. Conducting this analysis over a longer time frame would be a useful exercise, including the entire emerging market cycle, in which we will examine the correlation between EEM and global liquidity during strong and weak US dollar periods.
Similar to BTC, EEM also has specific risks that may temporarily break its long-term correlation with global Liquidity. Abnormal events in emerging market economies may temporarily disrupt its correlation with the global Liquidity trend. These abnormal events may be specific to a particular country or region, including political instability, geopolitical risks, natural disasters, currency devaluation, capital outflows, local regulatory developments, and financial/economic crises.
