BTC: Global Liquidity Barometer

Author: Sam Callahan, Lyn Alden; Translation: Bilingual Blockchain

Sam Callahan is a research analyst at Swan Bitcoin, a Financial Institution focusing on the Cryptocurrency field, where he primarily studies market trends of BTC, macroeconomic dynamics, and the intersection of digital asset and TradFi markets.

Recently, at the request of Lyn Alden, she wrote a research report exploring the close correlation between BTC price and global liquidity.

The following is the main text:

BTC has been in line with global Liquidity for 83% of any 12-month period, a higher proportion than any other major asset class, making it a powerful indicator of Liquidity conditions.

Although the correlation between BTC and global liquidity is high, it is not entirely unaffected by short-term deviations, especially during periods of extreme valuation, and may be influenced by specific events or internal dynamics of the market.

By combining the global Liquidity situation and the BTC on-chain valuation indicators, we can have a more detailed understanding of the cyclical changes of BTC, helping investors identify the moments when the internal dynamics of the market may temporarily lead BTC away from the Liquidity trend. Understanding how asset prices Fluctuate with global Liquidity changes has become key for investors to enhance returns and effectively manage risks. In today’s market, asset prices are increasingly directly influenced by Central Bank policies, and Liquidity conditions have become the primary driver of asset prices, with fundamentals no longer playing a decisive role alone.

Since the global financial crisis (2007-2008), this has become particularly evident. Subsequently, increasingly unconventional monetary policies have become the dominant force driving asset prices. Central Bank has turned the market into a big trade by controlling Liquidity leverage, as economist Mohamed El-Erian put it, Central Bank has become the “only protagonist”.

Stanley Druckenmiller also agrees with this, pointing out that ‘returns cannot drive the overall market; it is the changes in the Federal Reserve…follow Central Bank, follow Liquidity…that actually drive the market, while most people in the market are looking for returns and traditional indicators.’

This is particularly evident in the study of the close relationship between the S&P 500 index and global liquidity.

The explanation of the above chart can be reduced to a simple supply and demand relationship. If more funds are available to purchase assets, whether it is stocks, bonds, gold or Bitcoin, the prices of these assets usually pump. Since 2008, Central Bank has injected a large amount of fiat currency into the system, and asset prices have also risen. In other words, monetary inflation has driven asset price inflation.

In this context, understanding how to measure global Liquidity and the response of different assets to changes in Liquidity has become crucial for investors to cope with Liquidity-driven markets.

01 How to Measure Global Liquidity

There are many ways to measure global liquidity, but in this analysis, we will use global M2—a broad Money Supply indicator, which includes physical currency, demand deposits, savings deposits, money market securities, and other easily accessible forms of cash.

Bitcoin Magazine Pro provides a measure of global M2, which aggregates data from eight major economies: the United States, China, the Eurozone, the United Kingdom, Japan, Canada, Russia, and Australia. This indicator represents global liquidity well, as it reflects the total amount of funds available for spending, investment, and borrowing worldwide. In other words, it can be seen as a measure of the total amount of global credit creation and central bank currency printing.

It should be noted that global M2 is denominated in US dollars. Lyn Alden explains the importance of this in an article:

As the global reserve currency, the US dollar has become the primary unit of account for global trade, contracts, and debt, making the strength and weakness of the US dollar crucial. When the US dollar strengthens, the debt burden of various countries increases; whereas when the US dollar weakens, the debt burden decreases. The global Broad Money Supply, measured in US dollars, is a key indicator of global Liquidity. How fast is the creation of the legal currency unit? What is the strength and weakness of the US dollar in the global currency market?

When global M2 is denominated in US dollars, it not only reflects the relative strength of the US dollar, but also reflects the speed of credit creation, making it a reliable indicator for evaluating the global Liquidity condition.

While there are other ways to measure global Liquidity, such as considering short-term government debt or the global forex swap market, in the rest of this article, when we refer to “global Liquidity”, we will consider it as “global M2”.

02 Why BTC Could Be the Purest Barometer of Liquidity

One of the assets that has shown a strong correlation with global Liquidity over the years is BTC.BTC tends to perform well when global Liquidity expands, but performs poorly when Liquidity contracts. This dynamic has led some to refer to BTC as a “Liquidity barometer”.

The figure below clearly shows how the price of Bitcoin remains consistent with global Liquidity changes.

Similarly, comparing BTC with the annual year-on-year change in global Liquidity further highlights the close relationship between the two. When Liquidity increases, BTC price pumps; when Liquidity decreases, BTC price falls.

The above chart shows that the price of BTC is very sensitive to global Liquidity changes. But is it really the most sensitive asset to Liquidity in today’s market?

Overall, there is a more significant correlation between risk assets and liquidity conditions. In an environment of abundant liquidity, investors tend to adopt higher risk/high return investment strategies and allocate funds to assets perceived as riskier. Conversely, when liquidity tightens, investors typically shift towards assets they consider safer. This can explain why assets like stocks usually perform well when liquidity increases.

However, stock prices are also influenced by factors unrelated to Liquidity. For example, the performance of stocks is partially driven by earnings and dividends, so their prices are often correlated with economic performance. This can weaken the pure correlation between stocks and global Liquidity. In addition, U.S. stocks are influenced by passive fund inflows from retirement accounts such as 401(k)s, which impact their performance regardless of Liquidity conditions. These passive fund inflows may provide a buffer for U.S. stocks during Liquidity Fluctuation, reducing their sensitivity to global Liquidity conditions.

The relationship between gold and Liquidity is even more complex. On the one hand, gold benefits from increased Liquidity and a weakening dollar; on the other hand, it is also seen as a safe-haven asset. When Liquidity tightens and the market turns to safe-haven behavior, investors seek safety and may increase their demand for gold. Therefore, even if Liquidity is lost from the system, the price of gold may still perform well. This means that the performance of gold is not necessarily closely related to Liquidity conditions. Similarly, bonds are also considered safe-haven assets, so their correlation with Liquidity conditions may be low.

Returning to BTC, unlike stocks, BTC does not have returns or dividends, nor does it have structural buying pressure affecting its performance. Compared to gold and bonds, during BTC’s adoption cycle, most capital pools still consider it a risky asset. This may keep BTC relatively pure in terms of global liquidity correlation.

If this is true, it is a valuable insight for BTC investors and traders. For long-term holders, understanding the correlation between BTC and Liquidity can provide deeper insights and help analyze the driving forces behind price movements. For traders, BTC is an effective tool to express views on the future direction of global Liquidity.

This article aims to explore the correlation between BTC and global Liquidity, compare their relationship with other asset categories, identify periods of correlation interruption, and share insights on how investors can use this information to gain an advantage in the future.

03 Correlation between Quantitative Bitcoin and Global Liquidity

When analyzing the correlation between BTC and global liquidity, the strength and direction of the correlation must be considered at the same time. The strength of the correlation reveals the degree of synchronization between two variables. A strong correlation means that changes in global M2 have a more predictable impact on BTC prices, whether they are in the same direction or in reverse. Understanding this strength is key to evaluating the sensitivity of BTC to global liquidity fluctuation.

By analyzing the data from May 2013 to July 2024, it is clear to see the strong sensitivity of BTC to Liquidity. During this period, the correlation between BTC price and global Liquidity reached 0.94, indicating a very strong positive correlation. This suggests that during this time frame, the BTC price is highly sensitive to changes in global Liquidity.

However, if we observe the 12-month rolling correlation, the average correlation between BTC and global Liquidity drops to 0.51. This is still a moderate positive correlation, but significantly lower than the overall correlation.

This indicates that the price of BTC has not maintained such a close connection with Liquidity on an annual basis. In addition, when observing the 6-month rolling correlation, the correlation further dropped to 0.36. This means that as the time frame shortens, the deviation between the price of BTC and its long-term Liquidity trend increases, suggesting that short-term price Fluctuation is more likely to be influenced by specific factors of BTC itself, rather than the Liquidity situation.

To better understand the correlation between BTC and global Liquidity, we compared it to other assets, including 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.

**Within the rolling 12-month time frame, BTC has the highest average correlation with global Liquidity, followed by gold. The correlation of stock indices is slightly weaker, while the correlation between bond indices and Liquidity is the lowest, which is in line with expectations.

When analyzing the changes in assets and global liquidity correlation on a year-on-year basis, the correlation of stock indices is slightly stronger than that of BTC, followed by gold and bonds.

One reason why stocks may have a closer correlation to global liquidity in year-on-year changes than BTC is the high fluctuation of BTC. BTC often experiences significant price fluctuations within a year, which may distort its correlation with global liquidity. In contrast, stock indices usually exhibit smaller price fluctuations, making them more consistent with the year-on-year changes in global M2. Nevertheless, in the year-on-year analysis, BTC still shows a moderate correlation with global liquidity.

**The above data highlights three key points:

1. The performance of stocks, gold, and BTC is closely related to global Liquidity; **

2）Compared with other asset classes, BTC has a relatively strong correlation overall, and has the highest correlation during the 12-month rolling period；

3) The correlation between BTC and global Liquidity weakens when the time frame is shortened.

The alignment of BTC and Liquidity makes it unique. As mentioned earlier, strong positive correlation does not guarantee that two variables always move in the same direction, which is particularly evident in volatile assets such as BTC, and may temporarily deviate from the long-term relationship with relatively stable indicators such as global M2. Therefore, by combining strength and direction, we can have a more comprehensive understanding of the interaction between BTC and global M2.

By examining the consistency of this relationship, we can better understand the reliability of its correlation, which is especially important for investors who follow long-term trends. If you know that BTC tends to follow the direction of global liquidity changes for most of the time, then you can have more confidence in predicting its future price action based on the changes in liquidity.

In terms of the stability of directional consistency, among all the analyzed assets, BTC has the highest directional consistency with global Liquidity. In the 12-month period, the probability 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.

The following chart further demonstrates the directionality consistency between BTC and global Liquidity over a 12-month period, compared to other asset classes.

These findings are very important, because they indicate that, although the strength of correlation may vary depending on the time frame, the direction of BTC’s price tends to align with global Liquidity. In addition, the direction of BTC’s price is closer to global Liquidity than any other traditional assets.

This analysis indicates that the relationship between BTC and global Liquidity is not only significant in strength, but also very stable in directionality. The data shows that BTC 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 driving factor for the long-term price performance of Bitcoin (BTC), so it should be taken into account when assessing BTC market cycles and predicting future price fluctuations. For traders, this means that BTC becomes highly sensitive investment vehicles expressing views on global Liquidity, suitable for investors with strong beliefs in Liquidity.

04 Identifying the Breaks in Long-term Liquidity Relationships of BTC

Despite the overall correlation between BTC and global Liquidity, research has found that BTC prices often deviate from the Liquidity trend in shorter rolling periods. These deviations may be due to internal market dynamics exerting a greater influence at certain times in the BTC market cycle, or triggered by specific events within the BTC industry.

These individual incidents refer to events occurring within the broader encryption industry, often leading to rapid changes in market sentiment or triggering large-scale liquidation. For example, major bankruptcies, Hacker attacks on trading platforms, regulatory developments, or the collapse of Ponzi Schemes are typical examples of such events.

By observing historical instances of 12-month rolling correlation between BTC and global Liquidity, it is clear that the price of Bitcoin often depegs from the Liquidity trend when major industry events occur. The chart below shows the breakdown of BTC and Liquidity correlation during these significant events.

Key events, such as the collapse of Mt. Gox, the dismantling of the PlusToken Ponzi Scheme, as well as the panic and dumping pressure caused by the collapse of Terra/Luna and the bankruptcy of multiple encryption lending institutions, have generally nothing to do with the global Liquidity trend.

The COVID-19 market crash in 2020 provides another example. In the widespread panic dumping and risk aversion, BTC initially experienced a sharp decline. However, with unprecedented liquidity injection measures taken by central banks, BTC quickly rebounded, highlighting its sensitivity to liquidity changes. The break in correlation at that time was mainly due to the sudden shift in market sentiment, rather than changes in liquidity conditions.

Although it is important to understand the impact of these individual events on the correlation between BTC and global liquidity, their unpredictability makes them less actionable for investors. However, as the BTC ecosystem matures, infrastructure improves, and regulatory transparency increases, I expect the frequency of these ‘black swan’ events to decrease over time.

05 How does the supply side dynamics affect the Liquiditycorrelation of BTC

Another significant pattern of BTC and Liquiditycorrelation weakening, except for a few events, is that it often coincides with periods when BTC prices reach extreme valuations and then sharply decline. This is particularly evident at the peak of the 2013, 2017, and 2021 Bull Markets, during which the Liquiditycorrelation of BTC became disconnected due to a significant fall in prices from high levels.

Although Liquidity mainly affects demand, understanding the distribution pattern of the supply side can also help identify periods when BTC may deviate from long-term correlation with global Liquidity. The main source of available supply is the profit-taking exit of old holders during BTC price pumps. In addition, there will also be new issuance from Block rewards in the market, but this part is relatively small and continues to decrease with each Halving event. During a Bull Market, old holders often sell and sell to new buyers until new demand saturates. At this saturation point, the peak of the Bull Market usually appears.

The key metric to assess this behavior is the HODL Wave of BTC for one year and above, which measures the percentage of BTC held by long-term investors for at least one year as a proportion of the total circulating supply. In simple terms, it reflects the proportion of available supply held by long-term investors at any given time.

Historically, this indicator tends to decline during a Bull Market, as long-term holders choose to sell; while it will rise during a Bear Market, as they will accumulate. The figure below emphasizes this behavior, with red circles marking peak periods and green circles representing bottoms.

This explains the behavior of long-term holders in the BTC cycle. Long-term holders tend to take profit and exit when BTC is considered overvalued, and tend to accumulate when BTC is considered undervalued.

The problem becomes… “How to determine whether BTC is undervalued or overvalued, so as to better predict when the supply will flood into or be withdrawn from the market?”

Although the data set is still relatively small, the market value to realized value Z-score (MVRV Z-score) has been proven to be an effective tool for identifying whether BTC has reached extreme valuation levels. The MVRV Z-score is composed of the following three components:

1）Market Cap - The current market Market Cap is calculated by multiplying the price of BTC by the total number of coins in circulation.

2) Realized Value - The average price of each BTC or Unspent Transaction Output (UTXO) from its last on-chain transaction, multiplied by the total circulating supply, is basically the on-chain cost basis of BTCholders.

3）Z-score - This score measures the deviation between market value and realized value, expressed in standard deviations, and highlights periods of extreme overvaluation or undervaluation.

When the MVRV Z-score is high, it means that there is a significant gap between the market price and the realized price, and many holders have unrealized profits. Although this may seem like a positive phenomenon, it could also be a signal that BTC is being overestimated or overbought, which means long-term holders may start distributing their BTC and making profits.

On the contrary, when the MVRV Z-score is low, the market price is close to or below the realized price, indicating that BTC is undervalued or Oversold - this is a good opportunity for investors to start accumulating.

When overlaying the 12-month rolling correlation between MVRV Z-score and BTC with global Liquidity, a clear pattern begins to emerge. It seems that when the MVRV Z-score sharply drops from historical highs, the 12-month rolling correlation also decreases. The red rectangles below highlight these periods.

This phenomenon suggests that when the BTC price reaches a very high valuation level and begins to adjust, the correlation between it and global liquidity may weaken. This weakened correlation reflects the impact of supply-side dynamics and the dominant role of market sentiment in price behavior. During these periods, long-term holders typically choose to sell for profit, while short-term traders may overreact to price fluctuations, leading to a disconnect between short-term trends in BTC prices and changes in global liquidity conditions.

This analysis provides investors with important insights to help them identify potential changes in the relationship between BTC and Liquidity, as well as potential market adjustments that may occur at high valuation levels.

This indicates that when BTC’s MVRV Z-score declines from a high level and the correlation with Liquidity weakens, internal market dynamics such as profit-taking and panic dumping may have a greater impact on BTC prices than global Liquidity conditions. At extreme valuation levels, BTC’s price movement is often driven more by market sentiment and supply-side dynamics rather than global Liquidity trends.

For traders and investors, this insight is crucial as it helps identify rare moments when BTC deviates from its long-term Liquiditycorrelation. For example, suppose a trader firmly believes that the US dollar will depreciate and that global Liquidity will rise in the next year. According to this analysis, BTC would be the best tool to express this view, as it serves as the purest barometer of Liquidity in the market.

However, these findings suggest that traders should first evaluate BTC’s MVRV Z-score or other similar valuation indicators before placing an order. If BTC’s MVRV Z-score shows extreme overvaluation, traders should still exercise caution despite positive liquidity conditions, as internal market dynamics may overwhelm liquidity conditions and trigger price corrections.

By simultaneously monitoring the long-term correlation of BTC with global Liquidity and its MVRV Z-score, investors and traders can better predict how the price of BTC will respond to changes in Liquidity conditions. This approach enables market participants to make wiser decisions and may increase the chances of success when investing or trading BTC.

06 Conclusion

The strong correlation between BTC and global Liquidity makes it an important barometer for investors and traders in the macroeconomic outlook. This correlation is not only strong, but also shows a high degree of directional consistency when compared to other asset classes. BTC can be seen as a mirror, reflecting the speed of global currency creation and the relative strength of the US dollar. Moreover, unlike traditional assets such as stocks, gold, or bonds, the correlation between BTC and Liquidity remains relatively pure.

However, the correlation of BTC is not perfect. Research has found that the strength of BTC’s correlation within shorter time frames will decrease, emphasizing the importance of identifying moments when the correlation between BTC and Liquidity may break. Internal market dynamics, such as specific shocks or extreme valuation levels, may cause BTC to temporarily deviate from global Liquidity conditions. These moments are crucial for investors, as they often mark price corrections or accumulation phase.

Combining global Liquidity analysis with on-chain indicators such as MVRV Z-score helps to better understand the price cycle of BTC and identify times when price is more likely to be driven by market sentiment rather than widespread Liquidity trends.

Michael Saylor once said grandiosely, “All your models are destroyed.” Bitcoin represents a paradigm shift in the nature of money itself. Therefore, no statistical model can perfectly capture the complexity of the phenomenon of Bitcoin, but certain models can serve as useful tools for decision-making, despite their imperfections. As an ancient proverb says, “Nothing in the world is absolute, and some models are still useful.”

Since the global financial crisis (2007-2008), Central Banks around the world have distorted the financial markets through unconventional policies, making Liquidity the primary driving factor of asset prices. Therefore, understanding the changes in global Liquidity is crucial for any investor looking to succeed in today’s market. In the past, macro analyst Luke Gromen described BTC as the ‘last functioning smoke alarm’ because it is able to signal changes in Liquidity conditions, and this analysis has been supported.

When the alarm bells for Bitcoin go off, investors should listen carefully in order to manage their risks effectively and position themselves appropriately to seize opportunities in future markets.