This research piece on the correlation between measures of liquidity and the price of Bitcoin was compiled and written by Sam Callahan, and commissioned and advised by Lyn Alden.
Published: September 2024
Executive Summary
- Bitcoin moves in the direction of global liquidity 83% of the time in any given 12-month period, which is higher than any other major asset class, making it a strong barometer of liquidity conditions.
- Bitcoin’s correlation with global liquidity is high but not immune to short-term deviations caused by idiosyncratic events or internal market dynamics, especially during periods of extreme valuation.
- Combining global liquidity conditions with Bitcoin on-chain valuation metrics provides a more nuanced understanding of Bitcoin cycles, helping investors identify moments when internal market dynamics may temporarily decouple Bitcoin from liquidity trends.
Introduction
Understanding how asset prices move in response to changes in global liquidity has become crucial for investors aiming to enhance returns and manage risk effectively. In today’s market, asset prices are increasingly shaped by central bank policies that directly affect liquidity conditions. Fundamentals alone are no longer the primary drivers of asset prices.
This has been especially true since the Global Financial Crisis (GFC). Since then, these unconventional monetary policies have increasingly become the dominant force moving asset prices. Central bankers pulling on their liquidity levers have turned the market into one big trade, or, as economist Mohamed El-Elrian puts it, central banks have become “the only game in town.”
Stanley Druckenmiller echoed this sentiment when he stated, “Earnings don’t move the overall market; it’s the Federal Reserve Board…focus on the central banks and focus on the movement of liquidity…most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”
This is particularly evident when examining how closely the S&P 500 has tracked global liquidity post-GFC.
The explanation for the chart above boils down to simple supply and demand. If there’s more money available to buy something, whether that’s stocks, bonds, gold, or Bitcoin, the prices of these assets will generally rise. Since 2008, central banks have flooded the system with more fiat currency, and asset prices have responded accordingly. In other words, monetary inflation fuels asset price inflation.
Given this backdrop, it has become critical for investors to 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, but for this analysis, we’ll use global M2—a broad measure of 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’s a good proxy for global liquidity because it captures the total amount of money readily available for spending, investing, and lending on a global scale. Another way to think about it is as a measurement of the total amount of credit creation and central bank money printing occurring in the global economy.
One nuance here is that global M2 is denominated in U.S. dollars. Lyn Alden explained why this is important in a previous article:
The reason dollar denomination is important here is because the dollar is the global reserve currency and thus the primary unit of account for global trade, global contracts, and global debts. When the dollar strengthens, it hardens the debts of various countries. When the dollar weakens, it softens the debts of various countries. Global dollar-denominated broad money is like a big liquidity metric for the world. How quickly are fiat currency units being created? And how strong is the dollar relative to the rest of the global currency market?
When global M2 is denominated in dollars, it encapsulates both the relative strength of the dollar and the pace of credit creation, making it a reliable proxy for measuring global liquidity conditions.
While there are alternative ways to measure global liquidity—such as accounting for short-duration government debt or global FX swap markets—for the remainder of this article, when you read “global liquidity,” think “global M2.”
Why Bitcoin Could Be the Purest Liquidity Barometer
Over the years, one asset that has exhibited a strong correlation with global liquidity is Bitcoin. As global liquidity expands, Bitcoin tends to thrive. Conversely, when liquidity contracts, Bitcoin tends to suffer. This dynamic has led some to refer to Bitcoin as a “liquidity barometer.”
The chart below clearly shows how Bitcoin’s price tends to track changes in global liquidity.
Similarly, comparing the year-over-year percent changes of Bitcoin and global liquidity also highlights how closely the two appear to move in tandem, with Bitcoin’s price rising when liquidity increases and declining when liquidity falls.
Given the charts above, Bitcoin’s price appears to be highly sensitive to changes in global liquidity. But is it the most sensitive asset in the market today?
Generally speaking, risk assets are more correlated with liquidity conditions. In a pro-liquidity environment, investors tend to adopt a risk-on approach, shifting capital into assets considered more high risk/high reward. On the contrary, when liquidity tightens, investors typically shift capital toward assets they perceive as safer. This explains why assets like stocks often perform well in rising liquidity environments.
However, stock prices are also influenced by other confounding factors unrelated to liquidity conditions. For instance, stock performance is partly driven by things like earnings and dividends, so their prices are also tied to the economy’s performance. This can negatively impact how purely stocks correlate to global liquidity.
In addition, U.S. equities benefit from structural buying through passive inflows from retirement accounts like 401(k)’s, which further influence their performance regardless of liquidity conditions. These passive flows could buffer U.S. stocks as liquidity conditions fluctuate, potentially making them less sensitive to global liquidity conditions.
Gold’s relationship with liquidity is more mixed. On one hand, it benefits from rising liquidity and a weakening dollar, but on the other hand, it’s also viewed as a safe-haven asset. During periods when liquidity contracts and risk-off behavior emerges, demand for gold can increase as investors seek safety. This means that gold’s price can hold up well even when liquidity is being drained from the system. For this reason, gold’s performance may not align as closely with liquidity conditions as other assets.
Bonds, like gold, are also seen as safe-haven assets, so their correlation with liquidity conditions is likely to be low.
This brings us back to Bitcoin. Unlike stocks, Bitcoin lacks earnings or dividends and doesn’t have a structural bid to impact 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. This potentially leaves Bitcoin with the purest correlation to global liquidity relative to other assets.
If true, this could be a valuable insight for both Bitcoin investors and traders. For long-term holders, understanding Bitcoin’s correlation with liquidity can provide deeper insight into what drives its price performance over time. For traders, Bitcoin offers a vehicle for expressing views on the future direction of global liquidity.
This article aims to deeply explore the correlation between Bitcoin and global liquidity, compare its relationship with that of other asset classes, identify periods when the correlation breaks down, and share insights on how investors can use this information to their advantage in the future.
Quantifying the Correlation Between Bitcoin and Global Liquidity
When analyzing the correlation between Bitcoin and global liquidity, it’s important to consider both the relationship’s magnitude and direction.
The magnitude of a correlation reveals how closely two variables move together. A stronger correlation suggests that changes in global M2 have a more predictable impact on Bitcoin’s price, whether it moves in the same or opposite direction. Understanding this magnitude is key to gauging how sensitive Bitcoin is to shifts in global liquidity.
When analyzing data between May 2013 and July 2024, Bitcoin’s strong sensitivity to liquidity is clear. During this period, Bitcoin’s price exhibited a correlation of 0.94 with global liquidity, reflecting a very strong positive correlation. This suggests that Bitcoin’s price has been highly sensitive to changes in global liquidity over that time frame.
When looking at the 12-month rolling correlation, Bitcoin’s average correlation with global liquidity falls to 0.51. This is still a moderately positive relationship but notably lower than the overall correlation.
This indicates that Bitcoin’s price doesn’t track liquidity as closely on a year-to-year basis. Furthermore, when examining the 6-month rolling correlation, the correlation further declined to 0.36.
This suggests that as the time frames get shorter, Bitcoin’s price deviates more from its long-term liquidity trend, indicating that short-term price movements are more likely to be influenced by factors specific to Bitcoin rather than liquidity conditions.
To better understand Bitcoin’s correlation with 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.
Over a rolling 12-month period, Bitcoin had the highest average correlation with global liquidity, followed closely by gold. The stock indices had the next strongest correlations, and, as expected, bond indices had the lowest correlations with liquidity.
When analyzing the correlation between the assets and global liquidity on a year-over-year (YoY) percentage change basis, stock indices exhibit a slightly stronger correlation than Bitcoin, followed by gold and bonds.
One reason stocks may show a tighter correlation with global liquidity than Bitcoin on a YoY percentage basis is Bitcoin’s high-magnitude volatility. Bitcoin often experiences large price swings within a year, which can distort its correlation with global liquidity. In contrast, stock indices typically exhibit less significant price movements, keeping them more closely aligned with the YoY percentage changes in global M2. Despite this, Bitcoin still demonstrates a moderately strong correlation with global liquidity when analyzed on a YoY percentage change basis.
The data above highlights three key takeaways: 1) The performance of stocks, gold, and Bitcoin is closely tied to global liquidity, 2) Bitcoin has a strong overall correlation and the highest correlation over 12-month rolling periods compared to other asset classes, and 3) Bitcoin’s correlation to global liquidity weakens as the time frame shortens.
Bitcoin’s Directional Alignment with Liquidity Sets it Apart
As we mentioned previously, a strong positive correlation doesn’t guarantee that two variables always move in the same direction as each other over time. This is especially true when one asset, like Bitcoin, is more volatile and may temporarily deviate from the long-term relationship with a less volatile metric like global M2. This is why combining the two aspects—magnitude and direction—can provide a fuller picture of how Bitcoin and global M2 interact over time.
By examining the directional consistency of the relationship, we can better understand the reliability of their correlation. This is especially true for those interested in long-term trends. If you know that Bitcoin tends to track the direction of global liquidity for the majority of the time, you can feel more confident predicting its future price direction based on shifts in liquidity conditions.
In terms of consistency of the directional alignment, out of all the assets analyzed, Bitcoin had the highest correlation with the direction of global liquidity. Bitcoin moved in the same direction as global liquidity in 83% of 12-month periods and 74% of 6-month periods, underscoring the consistency of the directional relationship.
The chart below further illustrates Bitcoin’s directional alignment with global liquidity over 12-month periods compared to other asset classes.
These findings are notable because they demonstrate that even though the strength of the correlation may vary based on the time frame, Bitcoin’s price direction generally aligns with the direction of global liquidity. Furthermore, its price direction more closely mirrors global liquidity than any other traditional asset analyzed.
This analysis shows that the relationship between Bitcoin and global liquidity is not only strong in magnitude but is also consistent in its directional alignment. The data reinforces the idea that Bitcoin is more sensitive to liquidity conditions than other traditional assets, particularly over longer time frames.
For investors, this means that global liquidity is likely a key driver in Bitcoin’s long-term price performance and should be considered when evaluating Bitcoin market cycles and forecasting future price movements. For traders, it means that Bitcoin offers a highly sensitive investment vehicle for expressing views on global liquidity, making it a top choice for those with strong liquidity convictions.
Identifying Breakdowns in Bitcoin’s Long-term Liquidity Relationship
Despite Bitcoin’s overall strong correlation with global liquidity, the findings indicate that Bitcoin’s price often diverges from liquidity trends over shorter rolling periods. These deviations are likely driven by internal market dynamics exerting greater influence than global liquidity conditions at certain points in Bitcoin’s market cycle or by idiosyncratic events specific to the Bitcoin industry.
Idiosyncratic events refer to incidents within the broader crypto industry that lead to rapid shifts in sentiment or trigger large-scale liquidations. Examples include major bankruptcies, exchange hacks, regulatory developments, or the collapse of Ponzi schemes.
Looking at past instances where the 12-month rolling correlation between Bitcoin and global liquidity weakened, it’s clear that Bitcoin’s price tends to decouple from liquidity trends around significant industry events.
The chart below illustrates how Bitcoin’s correlation to liquidity breaks down around these major events.
Key events such as the Mt. Gox collapse, the unraveling of the PlusToken Ponzi scheme, and the Crypto Credit Contagion—caused by the Terra/Luna collapse and the bankruptcies of several crypto lenders—generated fear and sell pressure that were largely disconnected from global liquidity trends.
The COVID-19 market crash of 2020 provides another example. Bitcoin initially dropped sharply amid widespread panic selling and risk aversion. However, as central banks responded with unprecedented liquidity injections, Bitcoin quickly rebounded, highlighting its sensitivity to shifts in liquidity. The breakdown in correlation around that time can be attributed to an abrupt shift in market sentiment rather than a change in liquidity conditions.
While the impact of these idiosyncratic events on Bitcoin’s correlation with global liquidity is important to understand, their unpredictability makes them less actionable for investors. That said, as the Bitcoin ecosystem matures, infrastructure improves, and more regulatory clarity emerges, I expect the frequency of these ‘Black Swan’ events to diminish over time.
How Supply-Side Dynamics Impact Bitcoin’s Liquidity Correlation
Beyond idiosyncratic events, another notable pattern during periods when Bitcoin’s correlation with liquidity weakens is that these instances often coincide with times when Bitcoin’s price reached extreme valuations followed by sharp declines. This is evident in the bull market peaks in 2013, 2017, and 2021, where Bitcoin’s correlation to liquidity decoupled as its price significantly dropped from elevated levels.
While liquidity primarily influences the demand side of the equation, understanding supply-side distribution patterns can also be helpful in identifying periods when Bitcoin might diverge from its long-term correlation with global liquidity.
The primary source of for-sale supply comes from older holders taking profit as Bitcoin’s price rises. Supply also hits the market from new issuance from block rewards, but this is much less and will only continue to decrease with each halving event. During bull runs, older holders often trim their positions and sell to new buyers until incoming demand becomes saturated. At this moment of saturation, bull market peaks typically occur.
A key metric for assessing this behavior is the Bitcoin 1+ Year HODL Wave, which measures the amount of Bitcoin held by long-term holders (at least one year) as a percentage of the total circulating supply. Basically, it measures the percentage of the total available supply that long-term investors are holding at any given point in time.
Historically, this metric declines during bull markets as long-term holders sell and rises during bear markets when they accumulate. The chart below emphasizes this behavior, with red circles marking cycle peaks and green circles indicating bottoms.
This illustrates the behavior of long-term holders throughout Bitcoin’s cycles. Long-term holders tend to take profit when Bitcoin appears overvalued and tend to accumulate when Bitcoin seems undervalued.
The question becomes…“How do you determine when Bitcoin is under or overvalued to better predict when supply will flood or be drained from the market?”
Although the dataset is still relatively small, the Market Value to Realized Value Z-Score (MVRV Z-score) has proven to be a reliable tool for identifying when Bitcoin has reached extreme valuation levels. The MVRV Z-score is based on three components:
1.) Market Value – the current market cap, calculated by multiplying the price of Bitcoin by the total number of coins in circulation.
2.) Realized Value – the average price at which each Bitcoin or 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 measures how far the market value deviates from the realized value, expressed in standard deviations, and highlights periods of extreme overvaluation or undervaluation.
When the MVRV Z-score is high, it means that a large gap exists between the market price and the realized price, meaning that many holders are sitting on unrealized profits. This intuitively is a good thing, but it can also be a signal that Bitcoin is overbought or overvalued—an opportune time for long-term holders to distribute their bitcoin and take some profit.
When the MVRV Z-score is low, it means that the market price is either near or below the realized price, indicating that Bitcoin is oversold or undervalued—an opportune time for investors to begin accumulating.
When the MVRV Z-score is overlaid with the 12-month rolling correlation between Bitcoin and global liquidity, a pattern begins to emerge. The 12-month rolling correlation appears to break down in periods when the MVRV Z-score declines sharply from historically high levels. The red rectangles highlight these time periods below.
This suggests that when Bitcon’s MVRV Z-score begins to fall from elevated levels and the correlation with liquidity breaks down, internal market dynamics—such as profit-taking and panic selling—may influence Bitcoin’s price more than global liquidity conditions.
At extreme valuation levels, Bitcoin’s price action tends to be more driven by market sentiment and supply-side dynamics rather than global liquidity trends. For traders and investors, this insight is valuable because it could help identify those rare instances when Bitcoin diverges from its long-term correlation with global liquidity.
For example, let’s say a trader is strongly convinced that the dollar will fall and global liquidity will rise over the next year. According to this analysis, Bitcoin would be the best vehicle for expressing his view due to its role as the purest liquidity barometer in the market today.
However, these findings suggest that the trader should first evaluate Bitcoin’s MVRV Z-score or similar valuation metrics before putting on the trade. If Bitcoin’s MVRV Z-score signals extreme overvaluation, traders should be cautious even in pro-liquidity environments, as internal market dynamics may override liquidity conditions and drive a price correction.
By monitoring both Bitcoin’s long-term correlation to global liquidity and its MVRV Z-score, investors and traders can better predict how Bitcoin’s price may respond to shifts in liquidity conditions. This approach allows market participants to make more informed decisions and may increase their odds of having a successful outcome when investing or trading Bitcoin.
Conclusion
Bitcoin’s strong correlation with global liquidity makes it a valuable macroeconomic barometer for investors and traders. Its correlation is not only strong but also has the highest degree of directional consistency with global liquidity conditions relative to other asset classes. One can think of Bitcoin as a mirror reflecting the rate 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 remains relatively pure.
However, Bitcoin’s correlation is not perfect. These findings showed how the strength of Bitcoin’s correlation declines over shorter time frames and also shed light on the importance of recognizing periods when Bitcoin’s correlation with liquidity is prone to breaking down.
Internal market dynamics, such as idiosyncratic shocks or extreme valuation levels, can cause Bitcoin to temporarily decouple from global liquidity conditions. These times are crucial for investors to identify, as they often mark price corrections or periods of accumulation. Combining the analysis of global liquidity with on-chain metrics, such as the MVRV Z-score, allows for a better understanding of Bitcoin’s price cycles and helps pinpoint when its price is likely to be driven more by sentiment rather than broader global liquidity trends.
Michael Saylor once famously said, “All your models are destroyed.” Bitcoin represents a paradigm shift in money itself. As such, no statistical model can perfectly capture the complexities of the Bitcoin phenomenon, but some can be useful tools to guide decision-making, even with their imperfections. As the old adage goes, “All models are wrong, but some are useful.”
Since the GFC, central banks have distorted financial markets with unconventional policies and made liquidity the main driver of asset prices. As a result, understanding shifts in global liquidity is critical for any investor looking to navigate the market successfully today. In the past, macro analyst Luke Gromen has described Bitcoin as the “last fully-functioning smoke alarm” due to its ability to signal changes in liquidity conditions, and this analysis supports this label.
When Bitcoin’s sirens ring, investors would be wise to listen so that they can manage risk and position themselves appropriately to capitalize on future opportunities in the market.
Appendix
One interesting finding from this analysis was that international equity ETFs such as EEM and VT had a weaker correlation to global liquidity compared to the S&P 500. Traditionally, investors have turned to Emerging Market stocks to express views on global liquidity. There were a number of reasons for why this was the case:
1.) Emerging Market equities are generally riskier than Developed Market equities. As such, they are widely considered to be more sensitive to changes in global liquidity conditions.
2.) Emerging Market equities do not have the same structural bid from retirement accounts like U.S. stocks, which can distort their relationship with global liquidity.
3.) Emerging Markets are heavily dependent on foreign financing. According to the BIS, Emerging Market economies currently hold trillions of dollars worth of dollar-denominated debt. This makes them more sensitive to changes in global liquidity because when liquidity tightens and the U.S. dollar strengthens, it becomes more expensive for these countries to service their dollar-denominated debt. On top of the increased servicing costs, it also becomes more costly for them to continue borrowing in the future.
During the period these correlations were analyzed, the dollar was in a strong dollar cycle, which strained Emerging Market economies and influenced the whole dataset.
As a result, over the past decade, the S&P 500 has outperformed EEM, reflecting the challenges faced by Emerging Markets in a strong dollar environment.
When looking at the two charts together, it’s clear that there have been multiple periods over this time frame when SPY and EEM’s price action have diverged, with SPY rising and EEM falling or moving sideways.
The chart below emphasizes how SPY and EEM have diverged at various points, with SPY rising while EEM either fell or moved sideways.
This divergence explains why EEM’s correlation with global liquidity may not be as strong over this time period as readers may have expected. It would be a useful exercise to perform this analysis over a longer time frame to include a full Emerging Market cycle, where we investigate how correlated EEM is to global liquidity during a strong and weak dollar cycle.
Similar to Bitcoin, EEM also comes with specific risks that can temporarily break its long-term correlation with global liquidity. Idiosyncratic events occur in Emerging Market economies that can temporarily throw off their correlation with global liquidity trends. These idiosyncratic events could be specific to a particular country or region and include political instability, geopolitical risks, natural disasters, currency devaluations, foreign capital flight, local regulatory developments, and financial/economic crises.
Investors and traders need to be aware of these risks before they try to use EEM as a way to express a view on global liquidity. This analysis shows that Bitcoin has a stronger correlation but also moves in the same direction as global liquidity much more frequently than EEM. In addition, Bitcoin offers several advantages: it’s a decentralized asset with no direct exposure to regional economic instability, making it less susceptible to local idiosyncratic shocks. Bitcoin is also a global asset, reducing the impact of country-specific events and regulatory changes. This makes it more of a consistent gauge of global liquidity than EEM, which can be significantly affected by emerging market-specific issues. Thus, Bitcoin provides a vehicle that is a purer reflection of global liquidity trends.
