What Drives Bitcoin: Money Or Liquidity?

Money Matters, Credit Counts, But Liquidity Leads

Bitcoin has two worthy dimensions: (1) it is systematically influenced by at least three key macro finance variables, and (2) it is a barometer of Global Liquidity rather than a substitute for it. The first confirms that the Bitcoin price is not a random walk and can be sensibly analyzed. Taken together, the two results mean that Bitcoin can serve as a decent portfolio hedge against monetary inflation, namely the deliberate devaluation of paper money by governments.

The pie chart below shows the systematic influences we have been able to statistically extract from ten years of weekly data. Global Liquidity dominates (41%), followed by investors’ risk appetite (22%) and various gold components. A deeper dive into these latter influences reveals an error-feedback process that neatly makes gold and Bitcoin positively correlate strongly over the long-term, i.e. they trend together, but often move negatively in the short-term, i.e, they can cycle apart.

Definitions

Many investors acknowledge these generic monetary influences, but we still feel that Global Liquidity, rather than some hybrid World M2 measure or specific Fed Liquidity, is the appropriate measure to track. Fed Liquidity – a gauge of net liquidity injections into US money markets that we introduced in the book Capital Wars (2020) – is too narrow. It ignores the actions of other monetary authorities, such as China’s PBoC (People’s Bank), and fails to take into account the impact of private sector credit provision through banks, repo markets and collateral.

World M2 money supply is a better statistic, but it also falls short. Admittedly, it is straightforward to calculate, but the bane of economics is often that concepts that are the most easily measured take on the greatest importance, regardless of their doubtful efficacy. This ‘measurement without theory’ applies here.

According to Henry Kaufman, ex-Salomon Brothers research chief and one of the most influential American monetary economists in the last half century: “Money matters, but credit counts.” In other words, looking at the assets or credit side of the financial system gives insight into the dynamics of money. While similarly insisting on a credit view, we go a step further to bring Kaufman’s insights up-to-date by acknowledging, first, that liquidity can be created outside of traditional banks, via repo markets and shadow banks, and, second, that since liquidity is fungible, we need to embrace an international perspective. Hence, ‘Global Liquidity’. To summarize, Global Liquidity focuses on:

(1) Credit, not money

(2) Global, not national

(3) Collateral-based. It embraces repo markets and shadow banks and considers the collateral multiplier, not the textbook money multiplier

Correlation?

Put another way, M2 money is dominated by retail deposits in high street banks. In contrast, Global Liquidity is a wholesale measure of balance sheet capacity that that captures flows of savings and credit through the entire World financial system. Not surprisingly, Global Liquidity (US$180 trillion) is far bigger in size than M2 money (US$110 trillion). At times it has been as much as nearly two and a half times as large (when shadow banking booming ahead of the GFC – June 2008, 2.46x) and currently it is two-thirds bigger. This ‘gap’ is currently a whopping US$70 trillion: equivalent to more than two US economies in size! See chart:

Given this size difference, it is not surprising that the two measures enjoy a decent but far from compelling correlation. Essentially, they trend together, but cycle apart. The scatter diagram below reports annual growth rates since 2001. The regression line shows that M2 money has a flatter cycle, i.e. less variation, than Global Liquidity (beta = 0.286).

Prediction?

Of course the proof of the pudding is always in the eating, so does M2 do a better or worst job of predicting macro-finance variables? Since many investors use monetary variables to predict it, Bitcoin offers a useful test-bed. The scatter plot below evidences the long-term relationship between World M2 money supply, measured in US dollars, and Bitcoin using a 13-week forward looking prediction window. The data have been expressed as 6-week changes to eliminate ‘noise’. The results are statistically significant, but not especially robust.

Compare these with the results from an identical analysis, but with Global Liquidity replacing World M2. Again the results are statistically significant. They also appear both stronger and more robust. What’s more, the impact multiplier on Global Liquidity is larger, confirming Bitcoin’s greater sensitivity to Global Liquidity.

Causality?

If Global Liquidity comfortably wins this ‘horse race’ against World M2, it smashes World M2 in the following Granger test of statistical causality. Recall how statistical tests are often awkwardly expressed as ‘double negatives’. Here a low probability score mean that there is little chance that the factor has no effect, i.e. by implication it therefore has some significant impact.

The results highlight:

• Gold and Bitcoin interact together, but the linkages are hard to untangle

• Global Liquidity one-way Granger causes movements in Bitcoin and in gold. It also Granger causes World M2!

• World M2 does NOT Granger cause movements in gold prices or Bitcoin

Conclusion

Bitcoin’s price action is systematically tied to macro-financial forces, with Global Liquidity as the paramount driver. This validates its use as a hedge against monetary instability while dismissing narrower metrics like M2 money. Gold remains a parallel barometer, but Bitcoin’s unique sensitivity to liquidity innovations (e.g., as collateral) may amplify its role in the future. For investors, the lesson is clear: Monitor global credit conditions, not just central bank and retail bank balance sheets, to anticipate Bitcoin’s future moves.