Unlocking Bitcoin's Secrets: How Global Liquidity Drives Its Price

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, especially since the Global Financial Crisis (GFC).

As central banks flood the system with fiat currency, monetary inflation fuels asset price inflation, including Bitcoin.

How to Measure Global Liquidity

For this analysis, we’ll use global M2—a broad measure of money supply that includes physical currency, checking accounts, savings deposits, and money market securities. This measure is crucial for understanding liquidity conditions globally.

Why Bitcoin Could Be the Purest Liquidity Barometer

Bitcoin exhibits a strong correlation with global liquidity; as liquidity expands, Bitcoin thrives, and vice versa. This dynamic has led to Bitcoin being referred to as a “liquidity barometer.”

Generally speaking, risk assets are more correlated with liquidity conditions. However, Bitcoin’s lack of earnings or dividends means that it may have the purest correlation to global liquidity compared to other assets.

Quantifying the Correlation Between Bitcoin and Global Liquidity

Analyzing data from May 2013 to July 2024 reveals Bitcoin’s strong sensitivity to liquidity, with a correlation of 0.94. However, this correlation can weaken over shorter time frames.

Bitcoin’s Directional Alignment with Liquidity Sets it Apart

Bitcoin has the highest correlation with the direction of global liquidity, moving in the same direction 83% of the time over 12-month periods.

Identifying Breakdowns in Bitcoin’s Long-term Liquidity Relationship

Despite Bitcoin’s overall strong correlation with global liquidity, it can diverge from liquidity trends during significant industry events or periods of extreme valuation, influenced by idiosyncratic events.

How Supply-Side Dynamics Impact Bitcoin’s Liquidity Correlation

Understanding supply-side dynamics, such as profit-taking behavior from long-term holders during price peaks, helps in predicting when Bitcoin might diverge from its long-term correlation with global liquidity.

Conclusion

Bitcoin’s strong correlation with global liquidity positions it as a valuable macroeconomic barometer for investors and traders. Monitoring liquidity trends alongside on-chain metrics like the MVRV Z-score can provide insights into Bitcoin’s price movements and market cycles.