Since 2020, a distinct correlation between net liquidity, bitcoin and the S&P 500 has formed in the market. The latter sharply dropped out of the established pattern against the backdrop of the election race in the United States.
What global liquidity tells us
Liquidity in the markets usually refers to the inflow of money into the economy and as a consequence their inflow into cryptocurrencies and securities (or the reverse process with the withdrawal of funds and their withdrawal from intangible assets).
The growth of the indicator means the speed of transformation of assets into money, which increases security for market participants by reducing costs and the ability to use their capital at any time.
In the American financial system, this process is regulated by the Federal Reserve through changes in the credit rate. To raise it, the agency goes to the open market and sells, for example, U.S. government bonds, leaving ”cash” on its balance sheet. Thus, the liquidity level in the market is reduced;
When a rate cut is needed, the opposite happens. In this case, the Fed goes to the market and starts buying bonds, injecting liquidity. The agency directly influences the rates to create optimal conditions for lending through its appreciation or cheapening;
This process involves the balance sheet of the Fed, as well as the accounts of the U.S. Ministry of Finance and the Fed. Their aggregate forms the schedule of the so-called net liquidity, i.e. money flows from the monetary authorities into the financial system;
Starting with the coronavirus pandemic, risk asset markets, including cryptocurrencies, have had a fairly high correlation with the level of net liquidity. This continued to be the case until the US election race in 2024. Then the S&P 500 left this trio for a few months, leaving bitcoin to correlate with pure liquidity.
One could argue here: the U.S. is certainly a major financial center, but it is far from all the money in the world. This is indeed true. However, the graph of total global liquidity (US, UK, Japan, China and EU) looks about the same as in the States.
In doing so, markets found themselves in a situation where their longstanding correlation with liquidity in the financial system disappeared with the start of the US election campaign. After Donald Trump’s victory, the divergence only intensified.
Where the money for growth comes from
With the loss of similar dynamics in the market of risky assets (bitcoin and stocks), the indicators of monetary aggregates began to grow. In particular, experts often pay attention to M2, which reflects the amount of quickly available money in the economy.
However, the growth of this indicator can be caused by huge inflows into money market funds (MMFs), which are taken into account when calculating the aggregate. MMFs are invested only in short-term highly liquid instruments. They may also be held on deposit with banking institutions as collateral for lending activities.
And just when net liquidity lost its tie to risky assets, these markets accelerated:
As analysts at Morgan Stanley Bank noted in the Report for 2024, it was initially thought that investors might reallocate funds from MMFs to other asset classes, but economic uncertainty and other factors have led to increased demand. MMF assets reached $7 trillion in the U.S. Notably, retail funds even outperformed institutional funds in terms of inflows.
However, that doesn’t explain what has been pushing the stock and cryptocurrency markets up for most of 2024 and the beginning of this year.
So what is it?
The answers probably lie in the formation of new correlations that are still little talked about. Echoes of such analysis can be found in the reports of traditional financial organizations.
For example, the Bank for International Settlements (BIS) published an interesting observation about MMF-assets and the stablecoin market. Analysts found that it is ”stable coins” that are negatively affected by US monetary policy (MPC). In a report for the end of 2024, BIS experts concluded that a tightening of the MPC affects MMFs and stablecoins in different ways.
”Major MMFs tend to rise in the wake of monetary policy tightening, while the market capitalization of stablecoins declines,” the paper said.
The BIS indicated that the market capitalization of stablecoins has fallen by about 10 percentage points in three months. The decline is statistically significant and permanent, and the impact of the DCP on stablecoins is much greater than from stresses that cause bitcoin prices to fall of a similar magnitude.
Specifically, experts have pointed out that the drop in the overall capitalization of stablecoins is due to the reaction of Tether and USDC, which are in some ways MMFs because of the structure of the reserves backing the issuance.
When making initial assumptions about the impact of liquidity on cryptocurrency markets, it is worth considering the impact of the U.S. DCA specifically on stablecoins, which have become the centerpiece of the digital asset market. It is likely that all activity in future years will revolve around them. Such speculation is at least suggested by the actions of Donald Trump’s administration, which chose ”stable coins” as the primary tool for promoting the dollar to the masses.
This article was originally Posted on Coinpaper.com
