Market Cycles, Business Cycles & Liquidity Cycles - Part Two
Hello, and welcome to Part Two of our deep dive into cycles of every kind: business cycles, liquidity cycles & market cycles.
In Part One, we introduced the Rainbow Spaghetti Monster and his correlation with the broader market cycles, focusing in at first on the Business Cycle and its core components and proxies that I track to better determine where in the cycle we might be. If you have not yet read Part One, please go ahead and do so, as it will make the latter two parts of this series more intelligible.
Today, in Part Two, we will return to the Rainbow Spaghetti Monster, looking specifically at the Liquidity Cycle and the Crypto Cycle components: much like in the previous instalment, I will provide a basic overview of each component, along with why I track it and how it fits into the broader market cycle.
We will then wrap this all up in a neat little bow in Part Three of this series, diving deep into the current market cycle and future possible market cycles.
For now, let's dig into the Liquidity Cycle and its various proxies:
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THE LIQUIDITY CYCLE
Ah, the much-discussed and little-understood 'liquidity cycle'.
2024 has been the year in which the term 'liquidity' has come front and centre, largely driven by the growing prominence of the peerless work of Michael Howell at CrossBorder Capital - the modern godfather of liquidity cycles.
In fact, to illustrate just how much this perceived phenomenon has seized financial markets (at least online), let us take a look at Google search trends for the past 12 years for 'liquidity cycle' and 'global liquidity':
'LIQUIDITY CYCLE'
'GLOBAL LIQUIDITY'
Whilst the growth in searches for 'liquidity cycle' itself have been slow and steady, growing consistently since 2017, the search trends for 'global liquidity' are parabolic since 2022. And that's really the phrase on everyone's lips, particularly on FinTwit and CT.
The enigmatic global liquidity cycle has been espoused to drive all manner of things, including but not limited to financial asset prices, inflation and wealth inequality. Some - speaking here and there in hushed tones - have even put forth an argument for its capacity to raise the dead. That is, to raise those zombie companies which would otherwise be graveyard-bound were it not for the flood of supportive liquidity.
So, what is 'liquidity'?
Well, I'll provide a simple definition here, but for those who really want to dig into this stuff, please see my Financial Deepening post, published in September:
Liquidity is a measure of relative looseness or tightness of financial conditions, often tied to the size of central bank balance sheets and global money supply.
There are many, many proxies for liquidity, each with their own particular formula and methodology, and definitions of liquidity shift slightly depending upon the proxy being examined.
The purpose of all liquidity measures, however, is to ascertain the relative degree of supportiveness of collateral values in the financial sector, where tightness of liquidity is associated with weak support of asset prices and free-flowing liquidity is considered to be very supportive indeed.
Prior to the 1990s, this was not really something well-considered by the market, but as the world became more globalised and emerged from the 2008 financial crisis, the game changed in a material way, as outlined in the Financial Deepening post linked above.
For our purposes, all we really need to know is that there is a very strong correlation between 'liquidity' and asset prices, particularly crypto, where correlations can be as high as 90% depending upon the proxy used and the period in which it is considered. And notably, this flow of liquidity has continued to grow more cyclical post-2008.
So, let us reintroduce our Rainbow Spaghetti Monster, this time grouping the various liquidity measures and proxies I tend to track, mapped against BTC/USD:
GROUPED:
As you can see, whilst the measures were more disparate and decorrelated from asset prices at Bitcoin's inception (as one might expect of an asset in its infancy), they have grown more correlated with one another and more correlated with the price of Bitcoin as the cycles have progressed.
Generally speaking, peaks in these proxies are front-run by Bitcoin, as are troughs, but the trends are materially correlated: that is, when liquidity measures are tightening and falling, in general BTC/USD tends to underperform; and when they are rising and liquidity is in free flow, BTC/USD tends to fair well.
Now, let's look at the individual components, providing a brief overview of what precisely they measure and why they are significant:
INDIVIDUAL COMPONENTS:
GLOBAL LIQUIDITY INDEX
Global Liquidity Index is a comprehensive measure of liquidity, expressed by the following formula, courtesy of this indicator from ingeforberg:
Global Liquidity Index = Federal Reserve System (FED) - Treasury General Account (TGA) - Reverse Repurchase Agreements (RRP) + European Central Bank (ECB) + People's Bank of China (PBC) + Bank of Japan (BOJ) + Bank of England (BOE) + Bank of Canada (BOC) + Reserve Bank of Australia (RBA) + Reserve Bank of India (RBI) + Swiss National Bank (SNB) + Central Bank of the Russian Federation (CBR) + Central Bank of Brazil (BCB) + Bank of Korea (BOK) + Reserve Bank of New Zealand (RBNZ) + Sweden's Central Bank (Riksbank) + Central Bank of Malaysia (BNM)
So, this is a measure of the collective balance sheets of the largest central banks in the world, converted into Dollars; expansion of these balance sheets is shown by a rising Global Liquidity Index and vice-versa.
As we can see, there is a very clear correlation between period of rising global liquidity and strength in Bitcoin, whilst the correlation is less tight to the downside (although there is still clear underperformance during periods of tightening liquidity). Therefore, if we expect global balance sheet expansion, we should anticipate outperformance in BTC.
GLOBAL M2 / GLOBAL GDP
This is perhaps my favourite proxy for all things liquidity and it is the measure I use that relates to the phenomenon of Financial Deepening, as alluded earlier in this post. Again, if you have not read that post, it delves deeply into the underlying mechanisms driving speculative bubbles and the second-order effects of such mechanisms.
Global M2 divided by Global GDP is the inverse of the Velocity of Money, and it is calculated here via this indicator from miguefinance as follows:
Global M2 is the sum total M2 Money Supply of the 26 largest countries by GDP, converted into Dollars. Global GDP is the sum total GDP of the same countries, also converted into dollars. Divide Global M2 by Global GDP for the index seen above.
What this shows us is profound: it is the rate of growth of global money supply outpacing the rate of growth in goods and services produced globally, where periods of of growth in this ratio correlate highly with outperformance in Bitcoin and periods of decline in this ratio are generally unsupportive of Bitcoin. As an aside, this correlates more tightly the further out the risk curve you go.
The reason for this is that we are seeing the pool of nominal Dollars grow whilst the pool of goods and services that can be bought by those Dollars does not grow at the same rate, thus there are surplus Dollars that make their way into the financial sector and lead to deeper and deeper financialization of the global economy - hence, financial deepening.
When you understand this phenomenon, you understand why valuations of assets have far exceeded historical norms over the past two decades - and why they are likely to continue to do so whilst Global M2 / Global GDP keeps cycling higher...
M2SL/DXY
This is the US M2 Money Supply divided by the Dollar Index.
At its core, this is a measure of the growth rate of domestic Dollars vs. the strength of the Dollar internationally.
As M2SL/DXY rises (US M2 is growing faster than the Dollar is strengthening vs. other currencies), this is a proxy for growing liquidity in the financial system - in effect, a good barometer for the relative easiness or tightness of financial conditions. This is also indicative of weakening purchasing power of the Dollar itself via currency debasement. Lastly, a rising M2SL/DXY can indicate that international borrowers can access dollar liquidity more favourably. This all, in turn, leads to a growing risk appetite and capital flow into financial assets, as we can see from the ratio mapped vs BTC/USD.
As the ratio declines, the inverse is true - liquidity is tighter and financial conditions are less easy, often leading to a flight away from riskier assets.
As you can see, the three proxies highlighted above all roughly map one another across cycles...
DXY (INVERTED)
This one - the Dollar Index (inverted) - is somewhat self-explanatory, but for those who haven't see DXY plastered all over their X feeds, it is a measure of the strength of the US Dollar vs. a weighted basket of foreign currencies, primarily the Euro, Yen and Pound Sterling.
There is a weaker correlation here over the long-term, as both the Dollar and BTC have gone up and to the right over the past 16 years against everything else, but there are certainly periods - primarily during peaks in BTC/USD that correspond with peaks in Dollar weakness - following which the correlation becomes tighter. As we can see from above, the correlation between DXY (inverted) and BTC/USD are often during the steepest movements in Dollar strength - sharp periods of contraction or expansion in Dollar strength are highly correlated with BTC/USD, with Bitcoin suffering when the Dollar is strengthening in a parabolic manner (usually after it forms its cycle trough - here depicted as peaks).
Growing strength of the Dollar is a global liquidity vacuum, as much global trade is denominated in Dollars and thereby a stronger dollar makes borrowing more expensive and makes servicing debt more difficult. Again, the inverse is true in periods of trending Dollar weakness.
FED NET LIQUIDITY
'Fed Net Liquidity' is another term that appears to be making the rounds of late, and it is calculated as follows:
Fed Balance Sheet - Treasury General Account - Reverse Repo
This is a US-centric view of liquidity in the financial system, though given the Dollar's monopoly on reserve currency status, it is also useful for us global speculators - and, as you can see above, there is indeed somewhat of a correlation between changes in Fed Net Liquidity and appreciation or depreciation of BTC/USD, albeit this correlation is not as tight as more comprehensive measures, nor is it as tight to the downside (when Fed Net Liquidity goes down, Bitcoin has still historically had periods of outperformance, as it is a global asset).
The Fed Balance Sheet is simply the totality of assets held by the Federal Reserve; as the balance sheet expands, liquidity is injected into the financial system, generally speaking.
The Treasury General Account is the US Treasury's account at the Federal Reserve. As the balance grows, liquidity is in effect drawn from the financial system as funds are held out of circulation. There are usually particularly large spikes around tax season, for example. When the Treasury spends down the balance, this adds to liquidity conditions in the US.
The Reverse Repo is a tool used by the Fed to absorb excess liquidity, whereby the Fed sells securities to banks overnight but agrees to buy them back subsequently, thus effectively draining liquidity. As the RRP facility is used at a higher rate, more funds are held out of circulation, and vice-versa.
As more Dollars are held out of circulation at the Fed, Dollars become more scarce globally and this has ripple effects on the global economy.
In summary, an expanding Fed balance sheet with a declining Treasury General Account and Overnight Reverse Repo is a net liquidity gain for the global financial system and is supportive of loose financial conditions worldwide; and vice-versa.
As we found in Part One of this series, periods of loosening financial conditions are highly correlated with returns in risk assets.
RESERVE BALANCES
Reserve Balances - which can be found on FRED as WRESBAL - are the reserves held by banks at the Federal Reserve. Fairly self explanatory.
Importantly, these are the excess reserves available beyond required reserves that can be used immediately by banks for lending, investment or other purposes within the economy. The higher the reserve balances, the more liquidity is available within the financial system. Consider this a buffer rather than a drain, unlike the Treasury General Account where dollars are held out of circulation. As reserve balances fall, liquidity is sucked out of the banking system and banks are less likely to engage in credit creation etc.
Increases in Reserve Balances can also reduce the cost of borrowing globally, thereby improving global credit conditions.
Looking at the chart above, we can see how for large periods of time there is a strong correlation between growing reserve balances and outperformance in BTC/USD, whilst there is a weaker correlation once again to the downside. The downside correlation is particularly strong soon after reserve balances peak and begin to draw back.
USDCNH (INVERTED)
Finally, we have USDCNH - that is the Dollar-offshore Chinese Yuan FX pair.
Here, we can see USDCNH mapped vs BTC/USD and inverted, therefore a rising USDCNH here shows a weakening dollar (or strengthening yuan) and a falling USDCNH shows a strengthening dollar and weakening yuan (in effect, CNHUSD not USDCNH).
As we can see, the correlation was present but not as cyclical for the first couple of cycles in BTC/USD, but since 2016 the correlation appears to be growing and BTC/USD appears to peak a few months before the Yuan peaks in value versus the Dollar. Bitcoin tends to significantly front-run the troughs, bottoming out before the Yuan bottoms out against the Dollar, but since 2016 the most parabolic moves in BTC/USD occur after CNHUSD has bottomed and begins to trend higher. Further, if we look back at pre-2016, there was a strong positive correlation between Yuan strength and BTC/USD strength.
USDCNH is a proxy for both global liquidity and risk appetite for many reasons, one of which is simply that - as discussed above - a strengthening dollar can be liquidity negative and indicative of a flight to safety. China is also a major factor in the demand for commodities and thereby the global business cycle; as such, strength in CNHUSD (a stronger yuan) can be suggestive of optimism for global growth and likely also inflation expectations. As you will recall from the previous post, Bitcoin tends to do very well when both growth and inflation expectations are trending higher. Lastly, a strengthening yuan can caused by capital inflows into China and emerging markets, which is a good proxy for risk appetite globally.
THE CRYPTO CYCLE
Now, this is just a supplementary section, as there aren't necessarily many 'components' to the Crypto Cycle - rather, as we have established, the crypto cycle is driven more and more by the business and liquidity cycles as the sector matures. Nonetheless, there are 4 key indicators or tools I use to determine where we might be in the cycle, and they are grouped and mapped vs BTC/USD below:
GROUPED:
Unlike the Rainbow Spaghetti Monster, these four depicted above are not so much cyclical correlations as they are useful indicators. For the past two cycles in particular (given the available data), we can see that Bitcoin tops roughly around the time the Pi Cycle Top is triggered, which also aligns with prints above 6 for MVRV Z-Score, with Bitcoin and Stablecoin Dominance (inverted) peaking shortly thereafter.
Below, I have provided a brief overview of what I am looking at here and why it is helpful:
INDIVIDUAL COMPONENTS:
PI CYCLE
Somehow - through hitherto unknown black magic, perhaps - the Pi Cycle Top indicator has captured the prior three cycle tops within a few days.
The indicator uses the 111-day moving average and a 2x multiple of the price of the 350-day moving average; when the 111dMA crosses above the multiplier of the 350dMA, over the past three cycles we have found BTC/USD marks a cycle top. The reason for this being called the Pi Cycle Top is simply that 350/111 = 3.153 - not far off 3.142 (and apparently the closest mathematically one can get to Pi when dividing 350 by another whole number).
Whether this is voodoo or not, it has worked historically and people have continued to fade it and lose - at the very least, it is something I make sure I am tracking and if and when BTC starts looking like there will be convergence of the two MAs, best believe I will at least be derisking.
MVRV Z SCORE
MVRV Z-Score allows us to identify where Bitcoin might be overvalued or undervalued to an extreme degree, relative to fair value.
The indicator takes the Market Value of Bitcoin (price x circulating supply) and the Realised Value (the average price of the last time each Bitcoin was moved x circulating supply), and calculates a Z-Score between them, identifying extremities.
Historically, BTC/USD has formed its cycle high within a couple of weeks of hitting that red line above 6. Now, whilst we can't guarantee this triggers precisely again, it is certainly worth tracking and also suggestive of the approximate stage of the market cycle. If we're getting close to that 6, we should not be adding risk.
STABLECOIN MARKETCAP
Stablecoin Market Cap is very much self-explanatory - and not necessarily tightly correlated to the cycle - but certainly something you should be paying attention to.
It goes without saying that growth in Stablecoin Market Cap shows growth in flows into crypto, whilst contracting Stablecoin Market Cap shows flows out of crypto. We want to see that number continue to rip higher for the health of an uptrend in prices.
There's not much to discuss here but for those not already tracking this, make sure you keep an eye on it.
BITCOIN AND STABLECOIN DOMINANCE (INVERTED)
And lastly, Bitcoin + Stablecoin Dominance.
This has been inverted here for clarity, but we can see how the cumulative dominance of Bitcoin and Stablecoins peaks shortly after BTC/USD peaks, as the euphoria reaches its climax and everyone moves as far out the risk curve as is feasible. Whilst this is still at cycle highs (here represented as lows), we can make an educated guess that we remain mid-cycle; the further Bitcoin + Stablecoin dominance begins to fall, the further into the market cycle we are likely to be.
I think that's likely enough for Part Two of this series on Market Cycles, Business Cycles & Liquidity Cycles, and you should now have some understanding of how the Liquidity Cycle and Crypto Cycle components affect the broader market cycle and correlate with risk appetite, layered on top of the Business Cycle.
In Part Three, we will be looking at the current market cycle and future market cycles.
