Market Cycles, Business Cycles & Liquidity Cycles - Part One
This blog references an opinion and is for entertainment and informational purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
INTRODUCTION
Hello, and welcome to Part One of our deep dive into cycles of every kind: business cycles, liquidity cycles & market cycles.
Cycles drive everything in financial markets, and, for those who read our Financial Deepening post, you will know that these cycles only appear to be getting more correlated and more consistent as they progress, particularly since the late 90s, and more so post-2008.
If you haven't yet read that post, make a coffee and do that now - it'll make all of this subsequent stuff more interesting.
Sorted? Wonderful.
In this series of blog posts, we will be looking at these cycles more deeply, providing an overview of various components of the Business Cycle, the Liquidity Cycle and the Crypto Cycle, presenting our case for how this shapes the broader 'market cycle' - and yes, that means we'll be looking at how it affects your shitcoins.
By the end of this series, you should have an understanding of what drives the cycles and - more importantly - how to figure out where we might be within the cycle and how subsequent cycles may play out.
In Part One, I want to walk you through the Business Cycle components I pay particular attention to, providing a basic overview of what each component is useful for, why I track it and how it can drive the cycle.
In Part Two, we will look specifically at the Liquidity Cycle and the Crypto Cycle components, before wrapping it all up beautifully in Part Three of this series, where we dive specifically into the current market cycle and future market cycles.
But first, we need to have a bird's-eye view of these cycles and how they have played out historically, so that we might better understand how they could play out in the future...
So, I would like to introduce you to my 'master' cycle chart, colloquially known as the Rainbow Spaghetti Monster:
THE RAINBOW SPAGHETTI MONSTER
'Fear not the Rainbow Spaghetti Monster, for he is a predictable beast...' - Benjamin Graham, probably
And here's another view of the Rainbow Spaghetti Monster since the inception of Bitcoin, this time separating the cycle components and indicators from the price-action of BTC/USD:
Now, if this is making you feel queasy, have a glass of water and rest assured it will become clearer. The squiggles all have their place and their significance will be elucidated over the course of this post.
As you can see, however, there is a lot going on here - in fact, there are over a dozen components displayed on the above charts, all interwoven and mapping the past fifteen years of cycles.
For the sake of clarity, let's take a look at the same Rainbow Spaghetti Monster but focus in on the previous two full cycles, since ~2016:
And again, let's separate out the BTC/USD price-action for a (slightly) clearer view:
Already, your queasiness at the first set of charts should be dissipating, as you begin to see with greater clarity the correlations between these components.
But, for the sake of your sanity, let us zoom in once again, now looking solely at the past five years of cyclicality:
And here's your separated view:
And now a wave of relief should be washing over you...
No? Still queasy? It's all good - let's simplify.
In the above 5-year view of BTC/USD, we can see how there appears to be broad correlation not just across liquidity and business cycle components but also with price itself: in general, we tend to find that periods in which the cyclical components are rising are met with strength for Bitcoin, and conversely periods in which these components are falling often (though not always) correlate with underperformance. Whilst this correlation is obviously not 100%, we can see quite clearly that the business cycle and liquidity cycle plays a huge part in driving the Bitcoin cycle.
And what are the implications of this? Well, we'll really nail those down in future instalments of this series, but for now it will suffice to say that having a firm grasp of the trajectory of these cyclical components can help you determine where Bitcoin might be headed and where we are in the broader market cycle: for example, if the business cycle and liquidity cycle components are all or mostly rising, it is highly probable that we should be seeing Bitcoin outperformance; further, if they are all or mostly rising but have only in recent months emerged from a downturn, it is highly probable that we are mid-cycle for Bitcoin. If, instead, they have been rising in tandem for months and are broadly approaching their respective historical peaks, buyer beware.
If you look back at the first set of charts, the cycle components were relatively correlated in the first cycle, then more so in the second and so on, where now - post-Covid - they are so tightly correlated that understanding where only a handful of them are headed can truly reveal everything about the market cycle.
As a quick aside - given that we will delve more deeply into this in a future post - notice also how the peaks of these cycles are far more correlated than the troughs: broadly speaking, we find that the cyclical components all tend to peak around roughly the same time, which also coincides roughly with peaks in BTC/USD, whereas the troughs are much more widely dispersed. More on this another time...
For today, let us dig into the Business Cycle components, why I choose to track them and how they affect the broader market cycle:
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THE BUSINESS CYCLE
Now, I'd like to preface this section with the fact that there is simply no way we could look through every important component or indicator of the business cycle in one post - and, in fact, too much data is often distracting for our express purpose of mapping out market cycles and employing them for profitable speculation. We are not economists or CNBC talking heads.
I personally have a dozen or so key components that I track weekly, and that over the past fifteen years appear to be growing more correlated and more consistently cyclical in how they drive the broader market cycle.
These components cover the breadth of the business cycle, acting as proxies for various sectors, which in turn all represent growth or inflation - and that's all the business cycle is really about for me: are we growing or slowing, and is inflation rising or falling? This shapes policy around the easing and tightening of financial conditions, which is the most important thing for risk assets, in particular crypto.
Again, please do read my primer on Financial Deepening for more colour on this.
Below, we can see all of the Business Cycle components I track grouped and mapped to the price-action of Bitcoin since inception.
The Rainbow Spaghetti Monster grows less threatening by the minute...
GROUPED:
If we look at the above chart, we can see that early on in Bitcoin's existence, the business cycle had some effect on price-action, but given the size of the asset class it was less shackled to the peaks and troughs of these components. Since the December 2013 peak, however, there has been a strong correlation between an expansionary business cycle and outperformance in Bitcoin, and vice-versa. In fact, all three Bitcoin cycle tops since then have occurred around the business cycle peak, sometimes front-running this depending on which specific components we are looking at. The Bitcoin cycle bottoms for these past three cycles have occurred before the business cycle trough, with BTC often finding a floor a few months before we see the business cycle bottom out.
Now, let's look at the individual components here, providing a brief overview of their utility in our mapping of the market cycle:
INDIVIDUAL COMPONENTS:
NATIONAL FINANCIAL CONDITIONS INDEX
The first component I have highlighted here is simply the National Financial Conditions Index, which is a weekly measure released by the Federal Reserve Bank of Chicago as a real-time proxy for financial conditions in the US. They cover volatility, credit and leverage in the economy to assess the tightness or looseness of financial conditions.
Here, I have inverted the measure so that a rising NFCI is suggestive of loosening financial conditions, and vice-versa. As we can see, there is a strong correlation between looser financial conditions and outperformance in risk assets such as Bitcoin. Conversely, as financial conditions tighten, Bitcoin tends to struggle.
NET % OF BANKS TIGHTENING LENDING STANDARDS
Above, we can see the index for the Net Percentage of Banks Tightening Lending Standards, as released quarterly by the Senior Loan Officer Opinion Survey. This tracks changes in the willingness of banks to lend, where tightening lending standards is indicative of caution, whereas looser lending standards suggest economic confidence.
I have again inverted this, where a rising index shows improving willingness to lend and a falling index shows tighter lending standards. This index is important because looser lending standards can give us some indication as to where we are in the business cycle, suggestive of expansion and economic confidence. It also begets credit creation, which feeds into both growth and our financial deepening phenomenon, which is key for risk assets.
As you can see, there is a strong correlation with looser lending standards and strength in BTC/USD, and vice-versa, with Bitcoin tending to front-run the peak in bank willingness to lend by a few months.
HYG
Here, we can see the iShares High Yield Corporate Bond ETF, which is a real-time proxy for the demand for junk bonds, which are termed so due to the perceived higher risk of default. If there is demand for HYG, there is demand for junk bonds, which is a good measure of the risk appetite in the market. As we can see, demand for junk bonds is correlated with the rest of the risk curve, with Bitcoin tending to outperform during periods of strength for HYG, and vice-versa.
HY ICE CREDIT SPREADS
More important, however, than HYG itself is the high-yield credit spread, measuring the premium demanded by investors over government bonds. As one would imagine, wider credit spreads mean that more yield is being demanded to invest in junk bonds vs safe bonds, which itself is suggestive of risk in the economy. Narrow spreads, meanwhile, are indicative of confidence.
I have inverted the credit spread here for visual clarity, where peaks are the tightest spread (and thereby the greatest economic confidence) and troughs are the widest spreads (where there is significant perceived risk and low risk appetite).
This has a particularly strong correlation with Bitcoin for obvious reasons: if credit spreads are narrow, risk appetite is high, which means assets further out the risk curve benefit. This is also suggestive of expansion vs contraction in the business cycle, where widening spreads would be suggestive of downturn and narrowing spreads of continued growth. We can see that Bitcoin tends to perform well both as spreads narrow and as they consolidate at their narrowest in the cycle.
US MANUFACTURING ORDERS / NON-MANUFACTURING ORDERS
Now, above I have highlighted the ratio of Manufacturing New Orders vs. Non-Manufacturing New Orders, as a subcomponent of US ISM releases. New Orders are exactly what you would expect: the level of new purchase orders received for goods and services each month. This is key for understanding the future trajectory of a business and therefore the business cycle itself. A growing number above 50 indicates growth in new orders, month-on-month, and a falling number below 50 suggests contraction.
Here, I have divided the Manufacturing New Orders figure by the Non-Manufacturing New Orders figure to highlight the ratio between the two. The reason for this is simply that it is a good proxy for the business cycle itself, where Manufacturing New Orders growing faster than Non-Manufacturing New Orders is generally indicative of early recovery in a business cycle, whereas late cycle dynamics are more heavily weighted towards services, largely driven by consumer spending and therefore this ratio would begin to contract, as Non-Manufacturing New Orders dominate.
If we map this against BTC/USD, we can see how accurately expansion in this ratio correlates with outperformance in Bitcoin. In fact, the last three cycle peaks for Bitcoin have all coincided with cycle peaks in this ratio. (Funnily enough, they also correlate strongly with peaks in YoY Global Money Supply growth.) Whilst this ratio is bottoming out and rising, we should expect continued strength in BTC. When it turns and begins its cyclical downturn, same goes for BTC.
US PMI
And now that we've looked at New Orders specifically, we can look at the US PMI, which is a composite of the Manufacturing and Services sectors in the US economy. Again, above 50 = expansion and below 50 = contraction. This is a more broad overview of the US economy and its business cycle and we can see that it has a high correlation with the Bitcoin cycle. An expansionary business cycle = outperformance in Bitcoin, and vice-versa.
Given the breakdown of the New Orders ratio above, there is little else to add here about PMIs, but one thing to note is that the New Orders ratio is often a leading indicator of the composite PMI itself and therefore of the business cycle.
10-YEAR INFLATION BREAKEVENS
Here, we can see the 10-Year Breakeven Inflation Rate, which is a market-based measure of average expected inflation over the next 10 years, calculated as the difference between the yield in 10-Year Treasury Bonds and 10-Year Treasury Inflation-Protected Securities.
Bitcoin likes it very much when the average expected inflation rate has bottomed and is trending higher and it generally underperforms when 10-year inflation breakevens are declining. There is less of a direct correlation here than other measures, but this is still important to track. Bitcoin also tends to front-run peaks in 10-year inflation breakevens by about 6-9 months, which in turn tend to peak after Global M2 YoY growth has peaked and is turning lower. This measure also is useful for understanding what is likely to happen to financial conditions - tighter after peaks and looser after bottoms. The clearest correlation here is not to the downside but the upside: when breakevens have bottomed out and cycle higher, Bitcoin tends to do very well indeed.
10-YEAR REAL YIELD
The above chart shows the 10-year real yield (adjusted for inflation), which I have inverted for clarity. Thus, a rise in (1-)DFII10 here shows declining real yields, and a fall shows rising real yields.
What is interesting here is that whilst there is not a strong correlation as real yields rise, there is a clearer correlation as real yields fall. Falling real yields tend to be supportive of Bitcoin, whilst rising real yields have occurred whilst BTC has outperformed and underperformed historically.
Thus, if our expectation is that real yields will be falling for a prolonged period, we should expect to see strength in Bitcoin (and risk more broadly) during that period.
This one is not as key in my view for mapping out the market cycle, but still worth keeping an eye on.
COPPER/GOLD
Finally, we have the Copper/Gold ratio, mapped against BTC/USD, with cyclical bottoms in the ratio highlighted.
The clearest thing to point out here before I get to more mundane explanations is that when the Copper/Gold ratio marks out its cyclical bottom, Bitcoin tends to have its strongest period of outperformance subsequently. This was particularly true in the past two cycles, where Bitcoin performance prior to Copper/Gold marking a cycle low was decent but choppy and subsequent price-action was parabolic. The 2011-2013 cycle, however, simply mapped identically to the Copper/Gold cycle, with both BTC and the Copper/Gold ratio marking their cycle lows and peaks together.
Copper/Gold is a proxy for the business cycle: copper is an industrial metal, which tends to perform well as the business cycle is recovering and growing, suggestive of economic activity; gold is a safe-haven asset, outperforming during downturns and economic volatility. If copper is outperforming gold, we can consider that a real-time measure of economic strength globally. Conversely, if gold is outperforming copper, we can consider this indicative of economic uncertainty and slowdown.
This is one of the clearest measures to track for expected expansion and contraction of the business cycle and thereby of the expected outperformance in risk assets.
Now - as a final aside - there are innumerable other components one might be able to group in here that all play a part of the same cycle, such as average hours worked or shipment indices etc. (both pictured below), but you really can get too in the weeds with this stuff if you're not careful:
What is most important is to track the core proxies for growth and inflation, as these drive expectations for financial conditions.
I think that's likely enough for Part One of this series on Market Cycles, Business Cycles & Liquidity Cycles, and you should now have some understanding of how the Business Cycle components affect the broader market cycle and correlate with risk appetite.
In Part Two, we will be looking at the Liquidity Cycle more closely.
