Changes in money supply and monetary liquidity conditions can highly affect the trend of any financial market. The following analysis investigates this intermarket phenomenon by breaking down the basic components of money supply and liquidity. Later, a hypothetical global liquidity index is constructed to research the correlation between global liquidity and the S&P 500, the US Dollar Index, and Bitcoin.

Highlights:

• Money supply refers to the total amount of money circulating in the economy, while liquidity refers to how easily this money circulates
• Liquidity represents an interplay between the supply of and the demand for money and may be expressed as the difference between the expansion of money supply and the growth of money demand
• Equities are highly correlated to global liquidity conditions, but there can be significant delays (the time lag can be around 20 months)
• Risk-on financial assets such as tech stocks are more sensitive to changes in the global liquidity conditions than value stocks and other risk-off assets
• In investment analysis, liquidity should be assessed within an international context and not domestically

 

The Creation of Money and Money Supply

Let’s begin by how money is created in the first place. Two key players generate money in the economy: (i) central banks and (ii) commercial banks. These two players also constitute the so-called fractional-reserve banking system.

• Central banks can print money by creating or destroying liabilities on their balance sheet
• Commercial banks can also create money by providing more loans to the economy than their actual reserves

Notes:

• The implementation of monetary policies by central banks is facilitated by the adjustment of interest rates and open market operations
• By changing the reserve requirements of commercial banks, central banks define the amount of money that is available for banks to conduct transactions and offer loans 

The Fractional-Reserve Banking

Fractional-reserve banking refers to a banking system under which the public makes deposits to commercial banks, and commercial banks use that money to provide loans. Central banks set a minimum amount that banks need to hold in reserves; this is called the reserve ratio.

• Any change in the reserve ratio can highly affect the level of private liquidity

What happens to this money?

The newly created money is flowing directly/indirectly to the economy. A portion of this money will end up in the consumption of goods and services, and another portion will go to investment. Historically speaking, changes in the money supply can affect the prices of all financial assets.

The role of inflation

As the money supply expands, people tend to spend more. This means there is higher inflation, and thus, the purchasing power of money is reduced. Consequently, there is a new equilibrium between the quantity of money supplied and the quantity demanded. This process pushes the prices of goods and services higher. The prices of financial assets are also inflated, as are any other assets in the economy. During hyper-inflation, you should also expect the price of gold to surge.

 

 

Breaking Down Global Liquidity

Liquidity is an interplay between the supply of and the demand for money. According to BIS (sources), liquidity is “the funding that is unconditionally available to settle claims.”

In most cases, when money supply expands, liquidity increases, and when money supply shrinks, liquidity decreases. However, there are instances when money supply and liquidity move in opposite directions. For example, if money supply expands by 3%, but at the same time, economic activity and price inflation expand by 5%, then you should expect decreasing liquidity.

• Liquidity increases if the supply of money expands faster than the demand for money
• Liquidity decreases if the supply of money expands slower than the demand for money

Calculating Monetary Liquidity

Monetary liquidity can be calculated as:

■ Change in Liquidity Levels = Change (%) in Money Supply - Change (%) in Money Demand

The following chart presents the drivers of monetary liquidity.

Chart: Connecting Money Supply, Money Demand, and Monetary Liquidity

Money Supply and Liquidity can move in opposite directions

As mentioned above, liquidity includes money supply and demand. By breaking down money demand to its key drivers (inflation and economic output), we get the following formula:

■ Change in Liquidity Levels = Change (%) in Money Supply - Change (%) in Economic Activity - change (%) in Price Inflation

By solving the above formula, we can understand why there can be periods when money supply and liquidity move in opposite directions. According to the Mises Institute (sources), there have been notable instances when money supply and liquidity moved in separate directions:

• Between October 1929 and July 1932, the yearly growth rate of the money supply plunged from +8.3% to (minus) -14.5%, while liquidity increased from +0.2% to +26.5%
• Between October 1970 and August 1972, the yearly growth rate of the money supply increased from +5.5% to +6.1%, while liquidity fell from +6.3% to (minus) -7.9%.

Two types of liquidity

There are two general types of liquidity: the official (public) liquidity created by central banks and the private liquidity created by commercial banks.

• Central banks create official liquidity (Measured by MB money supply -Check at the end for a full list of “Ms”)
• Commercial banks create private liquidity (Measured by M1, M2, and M3 money supply)

More specifically:

Official (Public) Liquidity

Central banks can increase or decrease the official liquidity in the economy through their monetary operations (in their domestic currency).

• There is a wide range of other instruments that central banks can use to enhance domestic liquidity (for example, the mobilization of foreign exchange reserves, swap lines between central banks, and the exploitation of specific IMF liquidity facilities)
• During periods of financial stress, central banks may inject emergency liquidity into the economy

Private Liquidity

Private liquidity is provided by commercial banks and is driven by monetary policies, growth rates, and the general risk appetite.

• Private liquidity is highly cyclical and depends on the leveraging/deleveraging of private institutions
• Private liquidity is linked to international operations such as cross-border banking and investment capital movements
• Private liquidity should be assessed within an international context
• Shortages of global private liquidity can highly affect economic growth (as displayed in the 2008 financial crisis)

 

Linking Public and Private Liquidity to Form Global Liquidity

Official (public) and private liquidity are so closely related that they could be considered as one.

• Especially in times of financial crisis, private liquidity tends to collapse and depends on commercial banks’ access to sector funding
• Official and private liquidity are also related in normal market conditions (for example, through the collateral policies of central banks)
• According to studies, the reinvestment of foreign exchange reserves creates an additional interaction between official and private liquidity through cross-border capital flows

Economic Drivers Affecting Global Liquidity

There is a wide variety of economic drivers capable of affecting global liquidity conditions:

(i) Macroeconomic drivers, such as changes in economic growth, inflation, and real income

(ii) Monetary drivers, such as interest rate changes, reserve-ratio adjustments, and changes in the foreign exchange policies

(iv) New financial regulations and capital account policies

(v) The general appetite of investors for risk

(vi) The current phase of the business cycle and the stage of capital expenditure in this cycle

 

Measuring Global Liquidity

As explained above, global liquidity includes the official (public) and private liquidity. In investment analysis, global liquidity should be assessed through an international perspective. These are some reasons for having an international perspective:

• The cross-border operations of commercial banks
• Quite often, the same monetary policies are implemented simultaneously by major central banks around the world
• The business and interest rate cycles are quite similar in Western economies, even with a time lag
• The liberalization of capital flows and the increasing volume of cross-border investment flows (as more investors apply geographical diversification techniques to their portfolios)
• The increasing popularity of ETFs (enhancing further the cross-border capital flows)

In conclusion, liquidity should be assessed solely within an international context.

Combining data from Central Banks around the world

Practically, we can get a quick picture of global monetary conditions by summarizing the money supply data coming from major central banks. The major central banks include:

• The US Federal Reserve (FED)
• European Central Bank (ECB)
• Bank of England (BoE)
• Bank of Japan (BoJ)
• People’s Bank of China
• Swiss National Bank (SNB)
• Bank of Canada
• Reserve Bank of Australia (RBA)

Investigating the relation between Global Liquidity and the US Dollar Index

In the following chart, a hypothetical index is constructed that aggregates money supply data from the FED, ECB, BoJ, and People’s Bank of China. This index will hypothetically represent global liquidity.

In the chart below, the black line represents the global liquidity index while the yellow line is the US dollar index (USDX). Money supply data is calculated in US dollar terms.

Chart: Forming a Global Liquidity Index and the US dollar index (USDX)

If we take a close look at the above chart, we can see a general correlation between global liquidity and the US Dollar index. However, there are also periods of inverse correlation. For example, in early 2018, global liquidity started to dump while the US dollar index started to surge. Later, in early 2020, global liquidity started to surge, but the US dollar index started to decline. There could be many explanations for these periods of inverse correlations. For example, these inverse correlations could be attributed to black swan events or even to common cross-border investment flows:

• As more money is printed, the risk appetite of American investors increases, and thus they invest more in foreign assets, pushing the US Dollar index lower
• At times of limited global liquidity, American investors decide to repatriate some of the dollars they have invested abroad, pushing the US Dollar index higher

 

Investigating the Correlation Between Equity Markets and Liquidity Conditions

According to historical data, equities are highly correlated to global liquidity conditions.

• S&P 500 shows an 80-85% correlation to global liquidity
• Nasdaq shows a 90-95% correlation to global liquidity
• There can be delays between the movements of global liquidity and equity prices (the average time lag is around 20 months)

It is important to mention that not all individual stocks show the same correlation to global liquidity conditions. Risk-on assets, such as growth stocks, correlate more to global liquidity than risk-off assets, such as value stocks.

Chart: The Correlation of S&P500 with global liquidity

The above chart shows the high correlation between the S&P 500 and the global liquidity index we have created. However, we can observe a significant decoupling starting in 2023. This can be explained as follows:

• If the news is too good during bull markets, the stock market can periodically decouple from global liquidity
• Decoupling can also be observed during a strong bear market, given the news is too bad, especially during a black swan event

By moving to a higher-risk asset class, the following chart shows the correlation between Bitcoin and global liquidity conditions.

Chart: The Correlation of Bitcoin with global liquidity conditions

The Bitcoin price also shows a high correlation to global liquidity. Again, we can observe a significant decoupling starting in 2023. This can be explained by the fact that there were very bullish fundamental developments for the crypto market, including the institutionalization of the industry, ETFs, and the election of the Bitcoin-friendly president, Donald Trump.

• Generally, Bitcoin is sensitive to changes in global liquidity conditions, however, there can be a decoupling if there are fundamental changes in the market
• Bitcoin also shows a high correlation to the S&P 500, and that means when the S&P 500 decouples from global liquidity, so does Bitcoin

 

 

 

Measuring Money Supply

The different types of money supply are classified as "M"s and range from M0 (narrowest) to M3/M4 depending on the country (source Wikipedia).

Measuring Money Supply in Eurozone

• M1: Money in circulation plus overnight deposits
• M2: M1 plus deposits (up to two years)
• M3: M2 plus repurchase agreements and debt securities (up to two years)

Measuring Money Supply in the United States 

• M0: The total of all physical currency circulating in the economy (FED Notes + US Notes + Coins)
• M1: M0 plus demand deposits, checkable deposits, travelers, and most savings accounts
• M2: M1 plus money market accounts, retail money market mutual funds, and short-term deposits (up to $100,000)
• MZM: 'Money Zero Maturity' is calculated as M2 – time deposits + money market funds. MZM is important for the FED as historically predicts inflation
• M3: M2 plus large time deposits, institutional money, repurchase agreements, and eurodollars
• M4: M3 plus Commercial Paper and T-Bills

 

■ Connecting the Dots Between Money Supply, Liquidity, and the Course of Global Financial Markets

Giorgos Protonotarios, investment analyst

for TradingCenter.org (c), February 28th, 2025

Sources:

• BIS “Global liquidity – concept, measurement and policy implications”: https://www.bis.org/publ/cgfs45.pdf
• Mises Institute “The Difference between Money Supply & Liquidity”: https://mises.org
• Wikipedia, “Money supply”: https://en.wikipedia.org/wiki/Money_supply