Changes in money supply and liquidity conditions can strongly influence the trend of any financial market. The following analysis examines this intermarket effect by breaking down the main components of money supply and liquidity. Later, a hypothetical global liquidity index is created to study the correlation between global liquidity and the S&P 500, the US Dollar Index, and Bitcoin.

Highlights:

• Money supply is the total amount of money circulating in the economy, while liquidity measures how easily this money moves.
• Liquidity reflects the balance between the supply of and demand for money and can be expressed as the difference between money supply growth and money demand growth.
• Equities are closely linked to global liquidity, though there can be significant delays, with a time lag of around 20 months.
• Risk-on assets, such as tech stocks, are more sensitive to changes in global liquidity than value stocks and other risk-off assets.
• In investment analysis, liquidity should be evaluated in an international context, not just domestically.

The Creation of Money and Money Supply

Let’s start with how money is created. Two key players generate money in the economy: (i) central banks and (ii) commercial banks. Together, they form the fractional-reserve banking system.

• Central banks create money by adding or removing liabilities on their balance sheet.
• Commercial banks create money by issuing loans that exceed their actual reserves.

👉 Notes:

• The implementation of monetary policies by central banks is mainly facilitated by the adjustment of interest rates and open market operations
• By adjusting the reserve requirements for commercial banks, central banks determine how much money is available for banks to conduct transactions and issue loans

The Fractional-Reserve Banking

Fractional-reserve banking is a system in which the public deposits money in commercial banks, and the banks use that money to issue loans. Central banks set a minimum amount that banks must hold in reserves, known as 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 flows directly or indirectly into the economy. Part of it is spent on goods and services, while another part goes into investments. Historically, changes in the money supply can influence the prices of all financial assets.

The Role of Inflation

As the money supply grows, people tend to spend more. This leads to higher inflation, reducing the purchasing power of money. A new equilibrium forms between the money supplied and the money demanded, pushing up the prices of goods and services. Financial assets and other types of assets in the economy also rise in value. During hyperinflation, the price of gold typically surges as well.

Breaking Down Global Liquidity

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

In most cases, when the money supply grows, liquidity rises, and when the money supply shrinks, liquidity falls. However, there are instances when money supply and liquidity move in opposite directions. For example, if the money supply grows by 3% but economic activity and price inflation rise by 5%, liquidity is expected to decrease.

• Liquidity increases when the money supply grows faster than the demand for money.

• Liquidity decreases when the money supply grows more slowly 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 depends on both money supply and demand. By breaking down money demand into 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%.

Understanding the Two Types of Liquidity 

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

• Central banks create official liquidity (measured by MB money supply – see the full list of “Ms” at the end).

• Commercial banks create private liquidity (measured by M1, M2, and M3 money supply).

1️⃣ Official (Public) Liquidity

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

• They have a wide range of tools to boost domestic liquidity, such as mobilizing foreign exchange reserves, arranging swap lines with other central banks, and using specific IMF liquidity facilities.

• During financial stress, central banks may inject emergency liquidity into the economy.

2️⃣ Private Liquidity

Private liquidity is provided by commercial banks and is influenced by monetary policies, economic growth, and overall risk appetite.

• It is highly cyclical and depends on the leveraging or deleveraging of private institutions.

• It is linked to international activities, including cross-border banking and capital movements.

• Private liquidity should be analyzed in an international context.

• Shortages of global private liquidity can severely impact economic growth, as seen during the 2008 financial crisis.

Linking Public and Private Liquidity to Form Global Liquidity

Official (public) and private liquidity are so closely connected that they can often be considered as one.

• During financial crises, private liquidity tends to collapse and relies on commercial banks’ access to sector funding.
• Official and private liquidity are also linked in normal market conditions, for example, through central banks’ collateral policies.
• Studies show that reinvesting foreign exchange reserves creates further interaction between official and private liquidity via cross-border capital flows.

Economic Drivers Affecting Global Liquidity

Many economic factors can influence global liquidity conditions:

1. Macroeconomic drivers, such as changes in economic growth, inflation, and real income
2. Monetary drivers, such as interest rate changes, reserve-ratio adjustments, and changes in the foreign exchange policies
3. New financial regulations and capital account policies
4. The general risk appetite of investors
5. The current phase of the business cycle and the stage of capital expenditure within that cycle

Measuring Global Liquidity

As explained earlier, global liquidity includes both official (public) and private liquidity. In investment analysis, global liquidity should be evaluated from an international perspective. Here are some reasons for taking an international view:

• 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 overview of global monetary conditions by summarizing money supply data 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 created by combining money supply data from the FED, ECB, BoJ, and the People’s Bank of China. This index is intended to represent global liquidity.

• The black line shows the global liquidity index
• The yellow line shows the US Dollar Index (USDX)
• Money supply data is expressed in US dollar terms

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

A close look at the chart shows a general correlation between global liquidity and the US Dollar Index. However, there are periods of inverse correlation. For example, in early 2018, global liquidity began to decline while the US Dollar Index surged. Later, in early 2020, global liquidity increased, but the US Dollar Index fell.

There are several possible explanations for these inverse correlations, including black swan events or cross-border investment flows:

• As more money is printed, American investors’ risk appetite rises, leading them to invest more in foreign assets, which pushes the US Dollar Index lower.
• During periods of limited global liquidity, American investors may repatriate some of their foreign investments, driving the US Dollar Index higher.

Investigating the Correlation Between Equity Markets and Liquidity Conditions

Chart: The Correlation of S&P500 to Global Liquidity

The chart above shows the strong correlation between the S&P 500 and the global liquidity index we created. However, a notable decoupling begins in 2023. This can be explained as follows:

• During bull markets, if the news is overly positive, the stock market can temporarily decouple from global liquidity.
• Decoupling can also occur during severe bear markets, especially in the case of black swan events, when the news is extremely negative.

Shifting to a higher-risk asset class, the following chart illustrates the correlation between Bitcoin and global liquidity conditions.

Chart: The Correlation of Bitcoin to Global Liquidity Conditions

Bitcoin’s price also shows a strong correlation with global liquidity. Again, a notable decoupling appears starting in 2023. This can be explained by very bullish fundamental developments in the crypto market, such as the institutionalization of the industry, the introduction of ETFs, and the election of the Bitcoin-friendly president, Donald Trump.

• Generally, Bitcoin is sensitive to changes in global liquidity, but decoupling can occur when there are significant fundamental changes in the market.
• Bitcoin is also highly correlated with the S&P 500, meaning that when the S&P 500 decouples from global liquidity, Bitcoin tends to decouple as well.

Measuring Money Supply: A Comparison of the Eurozone and the US 

The different types of money supply are classified as “M” categories, ranging from M0 (the narrowest) to M3 or M4, depending on the country (source: Wikipedia).

 Measuring Money Supply in the 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 it 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

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