Recent liquidity crunches in the crypto market have seen Bitcoin retreat after months of sideways movement, with prices dipping as low as $86,000, a nearly 20% pullback from its highs. As the flagship of cryptocurrencies, Bitcoin's decline has sparked a collapse in altcoins, with market sentiment shifting from the greed of the meme era to panic.

Is the bull market in crypto still intact? Will Bitcoin break out higher? These are questions on many people's minds. However, Bitcoin's trajectory has now become closely tied to the global financial markets. Sam Callahan, a research analyst at Swan Bitcoin, has written an insightful article on the relationship between Bitcoin's price and global liquidity that is worth a read.

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Bitcoin aligns with the trend of global liquidity 83% of the time over any 12-month period, a higher proportion than any other major asset class, making it a powerful indicator of liquidity conditions.

Although Bitcoin has a high correlation with global liquidity, it is not immune to short-term deviations, especially during periods of extreme valuation, due to specific events or internal market dynamics.

Analyzing global liquidity conditions and on-chain valuation metrics for Bitcoin can provide a more nuanced understanding of its cycle changes, helping investors identify moments when market internals may temporarily pull Bitcoin away from liquidity trends.

Bitcoin: The Barometer of Global Liquidity?

Understanding how asset prices fluctuate with global liquidity has become key for investors to enhance returns and effectively manage risk. In today's market, asset prices are increasingly influenced by central bank policies, making liquidity conditions a primary driver of asset prices, rather than fundamentals alone.

This has been particularly evident since the global financial crisis (2007-2008). The increasing use of unconventional monetary policies has become the dominant force driving asset prices. Central banks, by manipulating liquidity levers, have turned the market into a giant trading floor, as described by economist Mohamed El-Erian. Stanley Druckenmiller also agrees, stating that "earnings don't drive the overall market; it's the Fed... focus on the central banks, focus on the changes in liquidity... most people are looking for earnings and traditional indicators, but what's driving the market is liquidity."

This is evident when examining the close correlation between the S&P 500 index and global liquidity.

Bitcoin: The Barometer of Global Liquidity?

The explanation for the above chart can be summed up in simple supply and demand. If more funds are available to purchase assets, whether stocks, bonds, gold, or Bitcoin, the prices of these assets typically rise. Since 2008, central banks have injected a massive 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 how different assets respond to liquidity changes has become key for investors to navigate a liquidity-driven market.

How to Measure Global Liquidity

There are many ways to measure global liquidity, but for this analysis, we will use Global M2—a broad measure of money supply that includes physical currency, demand deposits, saving deposits, money market securities, and other forms of easily accessible cash.

Bitcoin Magazine Pro offers a method to measure Global M2 by aggregating data from the eight major economies: the United States, China, the Eurozone, the United Kingdom, Japan, Canada, Russia, and Australia. This indicator well represents global liquidity as it reflects the total amount of funds available for spending, investment, and lending globally. In other words, it can be seen as a measure of the total global credit creation and central bank money printing.

It's important to note that Global M2 is denominated in U.S. dollars. Lyn Alden explains the significance of this in an article:

The U.S. dollar, as the global reserve currency, is the primary accounting unit for global trade, contracts, and debt, making the strength of the dollar crucial. When the dollar is strong, the debt burden of countries increases; when it's weak, the burden lightens. The globally denominated broad money supply is a key indicator of global liquidity. How quickly is the monetary unit being created? How strong is the dollar in the global money market?

When Global M2 is denominated in dollars, it not only reflects the relative strength of the dollar but also the speed of credit creation, making it a reliable indicator of global liquidity conditions.

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 discussion, when we refer to "global liquidity," we mean "Global M2."

Why Bitcoin Might Be the Purest Indicator of Liquidity

Over the years, one asset that has shown a strong correlation with global liquidity is Bitcoin. As global liquidity expands, Bitcoin typically performs strongly; when liquidity contracts, Bitcoin tends to underperform. This dynamic has led some to call Bitcoin a "barometer of liquidity."

The chart below clearly shows how Bitcoin's price has aligned with changes in global liquidity.

Bitcoin: The Barometer of Global Liquidity?

Comparing Bitcoin's price with the annualized change in global liquidity also highlights their close relationship. When liquidity increases, the price of Bitcoin rises; when it decreases, the price of Bitcoin falls.

Bitcoin: The Barometer of Global Liquidity?

Bitcoin's price is highly sensitive to changes in global liquidity. But is it really the most sensitive asset to liquidity in today's market?

Overall, risk assets have a more significant correlation with liquidity conditions. In a liquidity-rich environment, investors tend to adopt higher risk/high return investment strategies, shifting funds towards assets deemed riskier; conversely, when liquidity tightens, investors tend to move towards assets they consider safer. This can explain why assets like stocks perform well when liquidity increases.

However, stock prices are also influenced by factors unrelated to liquidity. For example, stocks are partly driven by earnings and dividends, so their prices are often related to economic performance. This may weaken the pure correlation between stocks and global liquidity. Additionally, U.S. stocks are influenced by passive inflows from retirement accounts (like 401(k)s), which may affect their performance regardless of liquidity conditions. These passive inflows could provide a buffer for U.S. stocks during liquidity fluctuations, making them less sensitive to global liquidity conditions.

Gold's relationship with liquidity is more complex. On one hand, gold benefits from increased liquidity and a weaker dollar; on the other hand, it is also seen as a safe-haven asset. During times of liquidity contraction and when the market turns to safe-haven behavior, investors seeking safety may increase their demand for gold. Therefore, gold's performance may not closely correlate with liquidity conditions. Similarly, bonds are also seen as safe-haven assets, so their correlation with liquidity conditions may be lower.

In contrast, Bitcoin, unlike stocks, does not have earnings or dividends, and it is not influenced by structural buying. Compared to gold and bonds, Bitcoin is still considered a risk asset in its adoption cycle. This may keep Bitcoin's correlation with global liquidity relatively pure.

For long-term holders, understanding Bitcoin's correlation with liquidity can provide deeper insights into the drivers behind price movements. For traders, Bitcoin is a powerful tool to express views on the future direction of global liquidity. If you strongly believe in liquidity trends, Bitcoin is a highly sensitive investment vehicle.

Quantifying Bitcoin's Correlation with Global Liquidity

When analyzing Bitcoin's correlation with global liquidity, it's essential to consider both the strength and direction of the correlation. The strength of the correlation reveals the degree of synchronization between the two variables. A 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 global liquidity fluctuations.

By analyzing data from May 2013 to July 2024, it's clear that Bitcoin is highly sensitive to liquidity. During this period, the correlation between Bitcoin's price and global liquidity reached 0.94, indicating a very strong positive correlation. This suggests that Bitcoin's price was highly responsive to changes in global liquidity during this time frame.

However, if we look at a 12-month rolling correlation, Bitcoin's average correlation with global liquidity drops to 0.51. This is still a moderate positive correlation but significantly lower than the overall correlation.

Bitcoin: The Barometer of Global Liquidity?

This indicates that Bitcoin's price does not consistently follow global liquidity trends on a yearly basis. Furthermore, when observing a 6-month rolling correlation, the correlation further declines to 0.36. This suggests that as the time frame shortens, Bitcoin's price may deviate more from its long-term liquidity trend, indicating that short-term price movements are more likely influenced by Bitcoin-specific factors rather than liquidity conditions.

To better understand Bitcoin's correlation with global liquidity, we compared it with other assets, including the 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.

In a rolling 12-month time frame, Bitcoin had the highest average correlation with global liquidity, followed by gold. The correlation for stock indices was slightly weaker, while the correlation for bond indices with liquidity was the lowest, which is as expected.

Bitcoin: The Barometer of Global Liquidity?

When analyzing the correlation of assets with global liquidity on an annualized basis, the stock indices had a slightly stronger correlation than Bitcoin, followed by gold and bonds.

The stronger correlation of stocks with global liquidity on an annualized basis may be due to Bitcoin's high volatility. Bitcoin often experiences significant price volatility within a year, which can distort its correlation with global M2.