Original author: Sam Callahan

Original Compilation: Luffy, Foresight News

Summary

• In any given 12-month period, BTC's direction is aligned with global Liquidity 83% of the time, a higher ratio than any other major asset class, making BTC a barometer of Liquidity.
• The correlation between BTC and global Liquidity is very high, but it is still subject to short-term deviations caused by special events or internal market dynamics.
• Combining the global Liquidity situation with the BTC on-chain valuation index can provide a more detailed understanding of the BTC cycle, helping investors identify internal market dynamics that may cause BTC to depeg from the global Liquidity trend.

The main asset classes and the correlation with global Liquidity

Background Introduction

For investors who want to increase returns and manage risk effectively, it has become crucial to understand how asset prices change with global liquidity. In today's market, asset prices are increasingly influenced by Central Bank policies that directly impact liquidity conditions. Fundamentals are no longer the primary driver of asset prices.

Since the global financial crisis, this phenomenon has become more apparent. Since then, these unconventional monetary policies have increasingly become the dominant force driving asset prices. Central Bank governors have turned the market into a big trade using Liquidity leverage, to quote economist Mohamed El-Elrian, Central Bank has become the "only game in town."

Stanley Druckenmiller also expressed the same view, saying: 'Profits do not affect the entire market, what affects the market is the Fed... following the central bank and the liquidity flow... most people in the market are following profits and conventional indicators. Liquidity is the factor that drives market development.'

This is particularly evident in the S&P 500 index.

Comparison of S&P 500 Index with Global M2 Trends

The correlation in the chart can be attributed to a simple supply and demand relationship. If more funds are available to purchase 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, currency inflation fuels asset price inflation.

In this context, investors must understand how to measure global Liquidity and how different assets respond to changes in Liquidity conditions, in order to better navigate these Liquidity-driven markets.

How to Measure Global Liquidity

There are many ways to measure global liquidity. In this report, we will use global M2: a broad measure of money supply that includes physical currency, checking accounts, savings deposits, money market securities, and other forms of readily available cash.

Bitcoin Magazine Pro provides a measure of global M2, which aggregates data from eight of the largest economies: the United States, China, the euro area, 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 spending, investment, and borrowing worldwide. Another way to think of it is as a measure of the total amount of credit creation and central bank money printing in the global economy.

One subtle difference here is that global M2 is priced in U.S. dollars. Lyn Alden explained in a previous article why this is important:

The importance of dollar pricing is that the dollar is the global reserve currency, and therefore the main unit of account for global trade, contracts, and debt. When the dollar strengthens, the debt of each country will become harder. When the dollar weakens, the debt of each country will become softer. The global Broad Money priced in dollars is like an important indicator of measuring global Liquidity. How fast the legal currency unit is created, and how strong the dollar is relative to other global currency markets.

When the 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 conditions.

Why BTC may be the purest Liquidity barometer

Over the years, there has been a strong correlation between an asset and global liquidity, and that asset is Bitcoin. As global liquidity expands, Bitcoin tends to thrive. Conversely, when liquidity contracts, Bitcoin is also affected. This phenomenon has led some people to refer to Bitcoin as the 'Liquidity Barometer'.

The following figure clearly shows how the price of Bitcoin (BTC) tracks changes in global Liquidity.

Similarly, comparing the year-on-year percentage changes of BTC and global Liquidity also highlights the synchronicity of their changes. When Liquidity increases, the price of BTC pumps, and when Liquidity decreases, the price of BTC falls.

As can be seen from the above figure, the price of Bitcoin is highly sensitive to changes in global Liquidity. But is it the most sensitive asset in today's market?

In general, risk assets have a higher correlation with liquidity conditions. In an environment with good liquidity, investors tend to adopt a risk preference strategy and transfer capital to assets with higher risk/return. Conversely, when liquidity tightens, investors usually transfer capital to assets they consider safer. This explains why assets such as stocks often perform well in an environment of increased liquidity.

However, stock prices are also influenced by factors other than Liquidity conditions. For example, stock performance is partially driven by factors such as earnings and dividends. This may weaken the correlation between stocks and global Liquidity.

In addition, the US stock market benefits from structural purchases of passive funds through 401(k) and other retirement accounts, regardless of the Liquidity situation, which will further affect its performance. These passive fund flows can buffer the US stock market during Liquidity Fluctuations, 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 increased Liquidity and a weaker US dollar. However, on the other hand, gold is also seen as a safe-haven asset. During periods of Liquidity contraction and risk aversion, investors seek safety and demand for gold may increase. This means that even if Liquidity weakens, the price of gold can still perform well. Therefore, the performance of gold may not be closely related to the Liquidity condition as other assets.

Like gold, bonds are also considered safe-haven assets, so their correlation with liquidity may be lower.

Finally, we come back to BTC. Unlike stocks, BTC does not have earnings or dividends, nor structural purchases that affect its performance. Unlike gold and bonds, in this stage of the BTC adoption cycle, most capital pools still consider it as a risk asset. Compared to other assets, BTC has the purest correlation with global liquidity.

If this is true, it is a valuable conclusion 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 breakdown, and share how investors can profit from this information in the future.

Quantitative correlation between Bitcoin and global Liquidity

When analyzing the correlation between BTC and global Liquidity, it is important to consider the magnitude and direction of the correlation.

The magnitude of correlation indicates the degree of correlation between two variables. The higher the correlation, the more predictable the impact of global M2 changes on BTC prices. Understanding this correlation is key to measuring BTC's sensitivity to changes in global liquidity.

Based on the data between May 2013 and July 2024, the strong sensitivity of BTC to Liquidity is evident. During this period, the correlation between the price of BTC 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 that time period.

Looking at the 12-month rolling correlation, the average correlation between BTC and global Liquidity has dropped to 0.51. This is still a positive correlation, but significantly lower than the overall correlation.

In addition, when checking the 6-month rolling correlation, the correlation further decreased to 0.36.

This indicates that as the time range shortens, the deviation between the price of BTC and its long-term Liquidity trend becomes larger, indicating that short-term PA is more likely to be influenced by internal factors of BTC 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 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.

In terms of 12-month rolling correlation, Bitcoin has the highest correlation, followed closely by gold, then stock indices, while bond indices have the weakest correlation with Liquidity.

When analyzing the correlation between assets and global Liquidity based on year-over-year percentage changes, stock indices exhibit a slightly stronger correlation than Bitcoin, followed by gold and bonds.

From a year-on-year percentage perspective, the correlation between stocks and global Liquidity may be higher than that of Bitcoin, partly because of the significant Fluctuation in the price of Bitcoin. 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 pronounced, and is more closely related to the year-on-year percentage changes in global M2. Nevertheless, the correlation between Bitcoin and global Liquidity remains quite strong in terms of year-on-year percentage changes.

The above data illustrates 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 strong overall correlation, with the highest correlation in a 12-month rolling period; 3) As the time frame shortens, the correlation between Bitcoin and global Liquidity weakens.

The direction of BTC is unique due to its alignment with Liquidity.

As we mentioned earlier, strong correlation does not guarantee that two variables will always move in the same direction over time. This is especially true when an asset (such as Bitcoin) has high volatility and may temporarily deviate from the long-term correlation with a less volatile indicator (such as global M2). This is why combining these two aspects (magnitude and direction) can provide a more comprehensive understanding of how Bitcoin and global M2 interact with each other over time.

By the consistency of correlation, we can better understand the reliability of their correlation. This is especially true for those interested in long-term trends. If you know that BTC tends to follow the direction of global liquidity most of the time, then you can have more confidence in predicting the future price direction of BTC based on changes in liquidity conditions. Among all analyzed assets, BTC has the highest correlation with the direction of global liquidity.

The following diagram further illustrates that, compared to other asset classes, BTC is directionally aligned with global Liquidity over a 12-month rolling period.

This suggests that, although the strength of correlation may vary over time frames, the price trend of BTC is generally aligned with global liquidity. In addition, its price movement is closer to global liquidity than any other traditional asset analyzed.

The relationship between BTC and global Liquidity is not only strong in size, 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 period of time.

For investors, this means that global Liquidity may be a key driver of BTC's long-term price performance, 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 vehicle that reflects views on global Liquidity, making it the preferred reference for those who have a strong belief in Liquidity.

The Deficiency of BTC and Liquiditycorrelation

Although BTC is generally highly correlated with global Liquidity, research shows that in shorter rolling periods, BTC prices tend to deviate from Liquidity trends. These deviations may be due to internal market dynamics having a greater impact on the BTC market at certain times in its cycle than global Liquidity conditions, or they may be due to specific events unique to the BTC industry.

Special events refer to events that occur within the cryptocurrency industry, which can lead to rapid changes in market sentiment or trigger large-scale liquidation. For example, the bankruptcy of large companies, hacker attacks on exchanges, regulatory crackdowns, or the collapse of Ponzi Schemes.

Looking back at the weakening of the 12-month rolling correlation between BTC and global Liquidity, it is obvious that the price of BTC often depegs from the global Liquidity trend during major industry events.

The figure below illustrates the correlation between Bitcoin and Liquidity depeg during major industry events.

The panic and dumping pressure caused by key events such as the collapse of Mt. Gox, the collapse of the PlusToken Ponzi Scheme, and the Terra/Luna collapse, are basically detached from the global liquidity trend caused by the Cryptocurrency Crisis of Confidence.

The COVID-19 market crash in 2020 is another example. In the widespread panic dumping and flight to safety, BTC initially plummeted. However, with unprecedented liquidity injections from Central Banks around the world as a response measure, BTC quickly rebounded, highlighting its sensitivity to liquidity changes. The disconnect in correlation at that time can be attributed to a sudden shift in market sentiment rather than changes in liquidity conditions.

Although it is important to understand the impact of these special events on BTC and global Liquiditycorrelation, 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 supplier affect the Liquiditycorrelation of BTC

Apart from special events, another noteworthy phenomenon during periods of weakened correlation between BTC and Liquidity is that these situations often coincide with the sharp drop in BTC price after reaching extreme valuations. This was evident at the peak of the Bull Market in 2013, 2017, and 2021, when the correlation between BTC and Liquidity depegged as its price sharply dropped from the high levels.

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 from the pump of BTC price. The new issuance of block rewards will also bring supply to the market, but the supply will be much less and will continue to decrease with each halving event. During a bull market, old holders usually reduce their positions and sell to new buyers until demand is saturated. This saturation point is often the peak of a bull market.

One key indicator to assess this behavior is the Fluctuation of BTC holdings for over 1 year, which measures the percentage of BTC held by long-term holders (at least one year) out of the total circulating supply. In other words, it measures the percentage of the total available supply held by long-term investors at any given point in time.

Historically, this indicator will decrease during a bull run period because long-term holders will be dumping; during a bear market period, long-term holders will be increasing their holdings, and this indicator will rise. The chart below shows this behavior, with red circles indicating cycle peaks and green circles indicating bottoms.

This explains the behavior of long-term holders in the BTC cycle. When BTC appears to be overvalued, long-term holders often sell to take profits, while when BTC appears to be undervalued, they often increase their holdings.

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?'

Although the dataset is still relatively small, the Market Value to 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. Value Realization: The average price of each BTC or UTXO in the last on-chain transaction multiplied by the total circulating supply - essentially the cost of BTCholder.

3. Z score: This score measures the degree of deviation between market value and actual 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 market price and realized price, which means that many holders are sitting on unrealized profits. This is intuitively a good thing, but it may also indicate that BTC is overbought or overvalued, which is a good opportunity for long-term holders to sell BTC and make profits.

When the MVRV Z-Score is low, it means that the market price is close to or below the realized price, indicating that BTC is oversold or undervalued, which is a good time for investors to start hoarding.

When the 12-month rolling correlation between MVRV Z-Score and global Liquidity of BTC is superimposed, a pattern begins to emerge. When MVRV Z-Score sharply declines from historical highs, the 12-month rolling correlation seems to fail. The red rectangles represent these periods.

This indicates that when BTC's MVRV Z-Score starts to decline from a high level and the correlation with Liquidity fails, 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, the PA of Bitcoin is often more influenced by market sentiment and supply-side dynamics than by global Liquidity trends. This finding is valuable for traders and investors as it can help identify when BTC deviates from its long-term correlation with global Liquidity.

For example, suppose a trader is confident that the US dollar will fall, and global Liquidity will rise in the next year. According to this analysis, BTC will be the best tool to prove his point, as it is the purest barometer of Liquidity in today's market.

However, traders should first evaluate the MVRV Z-Score of BTC or a similar valuation indicator before trading. If the MVRV Z-Score of BTC indicates an 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 between BTC and global Liquidity, as well as the 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 success when investing or trading BTC.

Conclusion

The strong correlation between BTC and global Liquidity makes it a macroeconomic barometer for investors and traders. Compared to other asset classes, the correlation between BTC and global Liquidity is not only strong, but also has the highest degree of directional consistency. People can view 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, the correlation between BTC and Liquidity is the most pure.

However, the correlation of Bitcoin is not perfect. Research has shown that the strength of Bitcoin's correlation decreases in the short term, which also indicates the importance of identifying periods of correlation breakdown between Bitcoin and Liquidity.

Internal market dynamics of BTC, such as special events or extreme valuation levels, may temporarily detach it from the influence of global Liquidity. These times are crucial for investors as they often mark 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 Liquidity trends.

Michael Saylor once said, "All of your models are broken." 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 be useful tools for guiding decisions. 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 the main driving factor of asset prices. Therefore, understanding the changes in global Liquidity is crucial for any investor who wants to successfully navigate the markets today. In the past, macro analyst Luke Gromen described BTC as the 'last fully functional smoke alarm' because it can signal changes in Liquidity conditions.

When the alarm of Bitcoin sounds, investors should listen wisely in order to manage risks and formulate strategies to fully utilize future market opportunities.