Bitcoin: A barometer of global liquidity

Author: Sam Callahan, Lyn Alden; Translated by Bai Hua Blockchain Sam Callahan is a research analyst at Swan Bitcoin, a financial institution focused on the cryptocurrency field. He mainly studies Bitcoin market trends, macroeconomic dynamics, and the intersection of digital assets and traditional financial markets. Recently, commissioned by Lyn Alden, he wrote a research report exploring the close correlation between Bitcoin prices and global liquidity. The following is the main text: **Bitcoin has been in line with the trend of 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 Bitcoin and global liquidity is high, **it is not completely immune to short-term deviations, especially during periods of extreme valuation, disrupted by specific events or internal market dynamics.** Combining the global liquidity situation and on-chain valuation indicators of Bitcoin can provide a more detailed understanding of Bitcoin's cyclical changes, helping investors identify moments when internal market dynamics may temporarily cause Bitcoin to deviate from the liquidity trend. **Understanding how asset prices fluctuate with changes in global liquidity has become key for investors to improve returns and effectively manage risks.** In today's markets, asset prices are increasingly directly influenced by central bank policies, and liquidity conditions have become the main driver of asset prices, with fundamentals no longer playing a decisive role. This has been particularly evident since the global financial crisis (2007-2008). **Since then, an increasing number of unconventional monetary policies have become the dominant force driving asset prices.** Central banks, by controlling liquidity leverage, have turned the market into a "big trade," as economist Mohamed El-Erian put it, with central banks becoming the "only player." Stanley Druckenmiller also agreed with this, pointing out: "Earnings don't drive the overall market; it's the Fed... Focus on the central bank, focus on changes in liquidity... **Most people in the market are looking for yields and traditional indicators, but what's driving the market is liquidity.**" This is particularly evident in the close correlation between the S&P 500 index and global liquidity. **The explanation for the above chart can be summarized as a simple supply and demand relationship. If there is more capital available to buy assets, whether stocks, bonds, gold, or Bitcoin, the prices of these assets will generally rise.** Since 2008, central banks have injected a large amount of fiat currency into the system, and asset prices have risen accordingly. 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 key 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 measure of money supply** that covers physical currency, demand deposits, savings deposits, money market securities, and other forms of readily available cash. Bitcoin Magazine Pro provides a way to measure 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 globally. In other words, it can be seen as a measure of global credit creation and central bank money printing.** It is important to note that global M2 is denominated in US dollars. Lyn Alden explained the importance of this in an article: The US dollar, as the global reserve currency, has become the primary unit of account for global trade, contracts, and debt, so the strength of the US dollar is crucial. When the US dollar strengthens, the debt burden of other countries increases; when the US dollar weakens, the debt burden decreases. The global broad money supply denominated in US dollars is a key indicator for measuring global liquidity. How fast is the creation of fiat currency units? How strong or weak is the US dollar in the global currency markets? **When global M2 is denominated in US dollars, it not only reflects the relative strength of the US dollar, but also reflects the pace of credit creation, making it a reliable indicator for assessing the state of global liquidity.** While there are other ways to measure global liquidity, such as considering short-term government debt or the global foreign exchange swap market, **in the following article, when we refer to "global liquidity," we will view it as "global M2."** ## 02 Why Bitcoin May Be the Purest Liquidity Barometer Over the years, one of the assets that has shown a strong correlation with global liquidity is Bitcoin. **As global liquidity expands, Bitcoin typically performs strongly; when liquidity contracts, Bitcoin often performs poorly. This dynamic has led some to refer to Bitcoin as a "liquidity barometer."** The chart below clearly shows how Bitcoin prices have tracked changes in global liquidity. Similarly, comparing the year-over-year changes in Bitcoin and global liquidity further highlights their close relationship. When liquidity increases, Bitcoin prices rise; when liquidity decreases, Bitcoin prices fall. From the above charts, it is clear that Bitcoin's prices are highly sensitive to changes in global liquidity. But is it really the most sensitive asset to liquidity in today's market? **Overall, the correlation between risk assets and liquidity conditions is more pronounced.** In an environment of ample liquidity, investors tend to adopt higher risk/higher return investment strategies, shifting capital towards assets perceived as riskier; conversely, when liquidity tightens, investors typically turn to what they consider safer assets. This can explain why assets like stocks tend to perform well when liquidity increases. **However, stock prices are also influenced by other factors unrelated to liquidity.** For example, stock performance is partly driven by earnings and dividends, so their prices are often correlated with economic performance. This may weaken the pure correlation between stocks and global liquidity. Furthermore, US stocks are influenced by passive fund inflows (such as 401(k)s), which can affect their performance regardless of liquidity conditions. **These passive fund inflows may provide a buffer for US stocks during liquidity fluctuations, making them less sensitive to global liquidity conditions.** **The relationship between gold and liquidity is more complex.** On one hand, gold benefits from increased liquidity and a weaker US dollar; on the other hand, it is also viewed as a safe-haven asset. When liquidity contracts and the market shifts to risk-off behavior, investors seeking safety may increase their demand for gold. Therefore, even if liquidity is withdrawn from the system, gold prices may still perform well. This means gold's performance may not be closely correlated with liquidity conditions. **Returning to Bitcoin, unlike stocks, it does not have earnings or dividends, nor does it have structural buying pressure affecting its performance. Compared to gold and bonds, which are also viewed as safe-haven assets, during Bitcoin's adoption cycle, most capital pools still perceive it as a risk asset. This may allow Bitcoin to maintain a relatively pure correlation with global liquidity.** If this holds true, this is a valuable insight for Bitcoin investors and traders. **For long-term holders, understanding Bitcoin's correlation with liquidity can provide deeper insights to analyze the driving forces behind price movements. For traders, Bitcoin can be an effective tool to express their views on the future direction of global liquidity.** This article aims to delve into the correlation between Bitcoin and global liquidity, compare it to other asset classes, identify periods of disruption in the correlation, and share insights on how investors can leverage this information to gain an advantage in the future.

03 Quantifying the Correlation Between Bitcoin and Global Liquidity

When analyzing the correlation between Bitcoin and global liquidity, both the strength and direction of the correlation must be considered. The strength of the correlation reveals the degree of synchronization between the two variables. Stronger correlation means that changes in global M2 have a more predictable impact on Bitcoin prices, whether in the same or opposite direction. Understanding this strength is key to assessing Bitcoin's sensitivity to fluctuations in global liquidity.

By analyzing data from May 2013 to July 2024, a clear picture of Bitcoin's strong sensitivity to liquidity emerges. During this period, the correlation between Bitcoin prices and global liquidity reached 0.94, indicating an extremely strong positive correlation. This suggests that Bitcoin prices were highly sensitive to changes in global liquidity during this time frame.

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

This indicates that Bitcoin's prices have not maintained such a tight link with liquidity on an annual basis. Furthermore, when observing the 6-month rolling correlation, the correlation further declines to 0.36. This means that as the time frame is shortened, the deviation between Bitcoin's prices and its long-term liquidity trend increases, suggesting that short-term price fluctuations are more likely to be influenced by Bitcoin-specific factors rather than liquidity conditions.

To better understand the correlation between Bitcoin and global liquidity, we compared it to 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.

Within the 12-month rolling time frame, Bitcoin has the highest average correlation with global liquidity, followed by gold. The stock indices have slightly weaker correlations, while the bond indices have the lowest correlations with liquidity, which is in line with expectations.

When analyzing the asset-to-global liquidity correlations in terms of year-over-year changes, the stock indices have slightly stronger correlations than Bitcoin, followed by gold and bonds.

One possible reason why stocks have stronger correlations with global liquidity changes on an annual basis compared to Bitcoin is Bitcoin's high volatility. Bitcoin often experiences large price swings within a year, which may distort its correlation with global liquidity. In contrast, stock indices typically exhibit smaller price fluctuations, making their annual changes more consistent with global M2 changes. Nevertheless, in the year-over-year analysis, Bitcoin still shows a moderately strong correlation with global liquidity.

The data above highlights three key points:

1) The performance of stocks, gold, and Bitcoin is closely related to global liquidity;

2) Bitcoin has the strongest overall correlation compared to other asset classes, and the highest correlation within the 12-month rolling period;

3) Bitcoin's correlation with global liquidity weakens as the time frame is shortened.

The directional consistency of Bitcoin's relationship with liquidity is distinctive. As mentioned earlier, strong positive correlation does not guarantee that the two variables will always move in the same direction, which is particularly evident in highly volatile assets like Bitcoin, which may temporarily deviate from their long-term relationship with relatively stable indicators (such as global M2). Therefore, considering both the strength and direction provides a more comprehensive understanding of the interaction between Bitcoin and global M2.

By examining the directional consistency of this relationship, we can better understand the reliability of its correlation, which is particularly important for investors focused on long-term trends. If you know that Bitcoin tends to follow the direction of changes in global liquidity most of the time, you can be more confident in predicting its future price movements based on changes in liquidity conditions.

In terms of the stability of directional consistency, Bitcoin has the highest directional consistency with global liquidity among all the analyzed assets. Within the 12-month time frame, Bitcoin moved in the same direction as global liquidity 83% of the time, and within the 6-month time frame, the probability was 74%, highlighting the consistency of the directional relationship.

The following chart further illustrates the 12-month directional consistency of Bitcoin with global liquidity compared to other asset classes.

These findings are significant because they indicate that, although the strength of the correlation may vary depending on the time frame, Bitcoin's price direction is generally consistent with the direction of global liquidity. Furthermore, Bitcoin's price direction is more closely aligned with global liquidity than any other traditional asset.

This analysis suggests that the relationship between Bitcoin and global liquidity is not only significant in terms of strength, but also highly stable in terms of directional consistency. The data shows that Bitcoin's sensitivity to liquidity conditions is higher than other traditional assets, especially over longer time frames.

For investors, this means that global liquidity is likely a key driver of Bitcoin's long-term price performance, and should be given due consideration when assessing Bitcoin market cycles and forecasting future price movements. For traders, this means that Bitcoin has become a highly sensitive investment tool for expressing views on global liquidity, suitable for investors with strong convictions about liquidity.

04 Identifying Disruptions in Bitcoin's Long-Term Liquidity Relationship

Although Bitcoin's overall correlation with global liquidity is strong, the research finds that Bitcoin's prices often deviate from liquidity trends over shorter rolling cycles. These deviations may be due to internal market dynamics exerting a greater influence at certain points in the Bitcoin market cycle, or due to events specific to the Bitcoin industry.

These individual events refer to occurrences within the broader cryptocurrency industry, which often trigger rapid changes in market sentiment or large-scale liquidations. Examples include major bankruptcies, hacking of trading platforms, regulatory developments, or the collapse of Ponzi schemes.

Observing historical instances of the 12-month rolling correlation between Bitcoin and global liquidity weakening, it is clear that Bitcoin's prices tend to decouple from liquidity trends during significant industry events. The chart below illustrates the disruptions in the correlation between Bitcoin and liquidity during these major events.

Key events, such as the Mt. Gox collapse, the unraveling of the PlusToken Ponzi scheme, and the crypto credit crunch triggered by the Terra/Luna collapse and multiple crypto lending platform failures, all led to panic and selling pressure that were largely unrelated to global liquidity trends.

The COVID-19 market crash in 2020 provided another example. In the widespread panic selloff and risk aversion, Bitcoin initially experienced a sharp decline. However, as central banks implemented unprecedented liquidity injections, Bitcoin quickly rebounded, highlighting its sensitivity to liquidity changes. The correlation disruption at the time was primarily due to the sudden shift in market sentiment, rather than changes in liquidity conditions.

While understanding the impact of these individual events on the correlation between Bitcoin and global liquidity is important, their unpredictability reduces their operability for investors. However, as the Bitcoin ecosystem matures, infrastructure improves, and regulatory transparency increases, I expect the frequency of these "black swan" events to decrease over time.

05 How Supply Dynamics Affect Bitcoin's Liquidity Correlation

In addition to individual events, another significant pattern of weakening in Bitcoin's liquidity correlation is often associated with periods when Bitcoin prices reach extreme valuations and subsequently experience sharp declines. This is particularly evident in the bull market peaks of 2013, 2017, and 2021, where Bitcoin's liquidity correlation becomes disconnected as prices significantly retrace from their highs.

Although liquidity primarily affects demand, understanding the distribution pattern of the supply side is also helpful in identifying periods when Bitcoin may deviate from its long-term correlation with global liquidity. The main source of sellable supply is the profit-taking of long-term holders when Bitcoin prices rise. Additionally, there are new issuances from block rewards in the market, but this part is relatively small and continues to decrease with each halving event. During bull markets, long-term holders tend to reduce their holdings and sell them to new buyers until new demand is saturated. This saturation point typically marks the peak of the bull market. The key indicator for evaluating this behavior is the Bitcoin 1-year and above HODL wave, which measures the percentage of the total circulating supply held by long-term investors with a holding period of at least one year. In simple terms, it reflects the proportion of the available supply held by long-term investors at any given time. Historically, this indicator typically declines during bull markets as long-term holders choose to sell, and rises during bear markets as they accumulate. The chart below highlights this behavior, with red circles marking cycle peaks and green circles indicating bottoms. This demonstrates the behavior of long-term holders in the Bitcoin cycle. Long-term holders tend to take profits when Bitcoin is perceived as overvalued, and tend to accumulate when Bitcoin is considered undervalued. The question becomes... "How can we determine if Bitcoin is undervalued or overvalued in order to better predict when supply will flow in 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 proven to be an effective tool for identifying when Bitcoin has reached extreme valuation levels. The MVRV Z-score is composed of three components: 1) Market Value - the current market capitalization, calculated by multiplying the price of Bitcoin by the total circulating supply. 2) Realized Value - the average price at which each Bitcoin or unspent transaction output (UTXO) was last transacted on-chain, multiplied by the total circulating supply, essentially the on-chain cost basis of Bitcoin holders. 3) Z-score - this score measures the degree of deviation between the market value and the realized value, expressed in standard deviations, and highlights periods of extreme overvaluation or undervaluation. When the MVRV Z-score is high, it means there is a large gap between the market price and the realized price, with many holders enjoying unrealized profits. While this may seem positive, it can also be a signal that Bitcoin is overvalued or overbought - indicating that long-term holders may start to distribute their Bitcoin and take profits. Conversely, when the MVRV Z-score is low, the market price is near or below the realized price, suggesting that Bitcoin is undervalued or oversold - a good opportunity for investors to start accumulating. Overlaying the MVRV Z-score with the 12-month rolling correlation between Bitcoin and global liquidity reveals a clear pattern. When the MVRV Z-score drops sharply from historical highs, the 12-month rolling correlation also appears to decline. The red rectangles below highlight these periods. This phenomenon suggests that when Bitcoin prices reach extremely high valuation levels and begin to adjust, its correlation with global liquidity may weaken. This weakening correlation reflects the impact of supply-side dynamics and the dominant role of market sentiment in driving price behavior. During these periods, long-term holders typically choose to take profits, and short-term traders may overreact to price volatility, leading to a decoupling of Bitcoin's short-term price movements from changes in global liquidity conditions. This analysis provides important insights for investors, helping them identify potential shifts in the relationship between Bitcoin and liquidity, as well as the market adjustments that may occur at high valuation levels. This indicates that when Bitcoin's MVRV Z-score declines from high levels and its correlation with liquidity weakens, internal market dynamics (such as profit-taking and panic selling) may have a greater impact on Bitcoin's price than global liquidity conditions. At extreme valuation levels, Bitcoin's price movements tend to be more driven by market sentiment and supply-side dynamics rather than global liquidity trends. For traders and investors, this insight is crucial, as it helps identify those rare moments when Bitcoin's correlation with its long-term liquidity deviates. For example, if a trader is convinced that the US dollar will depreciate and global liquidity will rise over the next year, based on this analysis, Bitcoin would be the best tool to express this view, as it acts as the purest liquidity barometer in the market. However, these findings suggest that traders should first assess Bitcoin's MVRV Z-score or similar valuation metrics before placing their orders. If Bitcoin's MVRV Z-score indicates extreme overvaluation, the trader should remain cautious, as internal market dynamics may overwhelm the liquidity conditions and trigger a price correction, despite the positive liquidity environment. By simultaneously monitoring the long-term correlation between Bitcoin and global liquidity, as well as its MVRV Z-score, investors and traders can better predict how Bitcoin's price will respond to changes in liquidity conditions. This approach allows market participants to make more informed decisions and may improve their chances of success when investing or trading Bitcoin. Conclusion The strong correlation between Bitcoin and global liquidity makes it an important macroeconomic barometer for investors and traders. This correlation is not only strong but also highly consistent in direction compared to other asset classes. Bitcoin can be viewed as a mirror reflecting the speed of global money creation and the relative strength of the US dollar. Unlike traditional assets such as stocks, gold, or bonds, Bitcoin's correlation with liquidity remains relatively pure. However, Bitcoin's correlation is not perfect. Research has found that the strength of its correlation can decline over shorter time frames, highlighting the importance of identifying moments when Bitcoin's correlation with liquidity may break down. Internal market dynamics, such as idiosyncratic shocks or extreme valuation levels, can temporarily decouple Bitcoin from global liquidity conditions. These moments are crucial for investors, as they often signal price corrections or accumulation phases. Combining global liquidity analysis with on-chain metrics (such as the MVRV Z-score) helps better understand Bitcoin's price cycles and identify when prices are more likely to be driven by market sentiment rather than broad liquidity trends. As Michael Saylor famously quipped, "All your models are destroyed." Bitcoin represents a paradigm shift in the nature of money itself. As a result, no statistical model can perfectly capture the complexity of the Bitcoin phenomenon, but some models can serve as useful tools to guide decision-making, even if they are not perfect. As the old saying goes, "Nothing is absolute, but some models are still useful." Since the Global Financial Crisis (2007-2008), central banks have distorted financial markets through unconventional policies, making liquidity a primary driver of asset prices. Therefore, understanding changes in global liquidity is crucial for any investor seeking success in today's markets. In the past, macroanalyst Luke Gromen described Bitcoin as the "last working smoke alarm," as it can signal changes in liquidity conditions - an analysis that is further supported by this research. When Bitcoin's alarm bells ring, investors should listen carefully to effectively manage risk and position themselves appropriately to seize future market opportunities.