Bitcoin Strategy: The Macro Liquidity Release Valve

Bitcoin is driven by liquidity, not a change in the definition of "money"

Welcome to the promised report on how to analyze and trade Bitcoin. The difficulty of operating in today’s world is not primarily one of obtaining data but more about thinking and interpreting data correctly. On top of this, your interpretation of the data must correctly align with the temporal tensions that exist. This is why I always say:

Intro:

Let me first start by saying, that there are always different agents in markets using different signals to make decisions. Some agents only use fundamentals, others only use price, and some are simply targeting a weighting in a portfolio. This doesn’t summarize all the agents but it is important to know that people have different timeframes, goals, and signals for their decision making. It would be foolish to think that the price only moves based on what YOU think is optimal.

Additionally, just because someone explains why they think an asset should go up or down in the future, doesn’t mean that is actually why it will move in the future. For example, someone could have bought Bitcoin in 2019 and said they did it because of a palm reading session they had. This person would look incredibly “smart” in 2024 due to the amount of wealth they accumulated. People might think that palm reading is predictive of this type of price action in such a “revolutionary asset.”

I use the absurdity of a palm reading session (I am sure someone won’t like this comment but oh well) having predictive value on assets because this same dynamic exists for the narratives around any financial asset. The deceptive part of narratives today is that there is always a grain of truth in them. Thinking clearly lies in one’s ability to discern between the gray areas of life. A counterfeit $100 bill is deceptive because it looks like a real one.

How Do We Move Forward Then?

You might be asking if we can’t trust anyone, how in the world can we understand why anything happens? While we won’t be digging into the topic of epistemology or the philosophic depths of Godel, Escher, Bach (link) today, but we will take a very tangible and practical approach to correctly interpreting HOW and WHY Bitcoin moves the way it does.

Let’s start with a few items that are prerequisites for understanding any asset:

• First, there will always be seen and unseen elements connected to any asset. The time series of an asset is SEEN but there are always elements influencing the underlying supply and demand of the price that are UNSEEN.

• Second, conducting attribution analysis for an asset is critical for identifying the underlying drivers. The underlying drivers for any asset are likely to always be in a constant state of dynamically shifting. As a result, the driver that pushes the price up or down on a previous timeframe might not be (and is actually unlikely to be) the same driver moving the price up or down on a future timeframe. The result of conducting attribution analysis correctly is to frame the drivers of price correctly. From this foundation, you can make informed views on each underlying driver and the degree of its contribution to the overall price.

• Third, many times the underlying drivers of assets require prerequisite knowledge. For example, Bitcoin is directly connected to growth, inflation, and liquidity in the US market and other G7 countries. Many people don’t have an extensive understanding of these dynamics and as a result will only use technical signals. There is nothing wrong with specializing in a single driver of asset prices but this does limit your opportunity set for trades and lower the quality of your signal-to-noise ratio.

• Fourth, there is always an intended range of implications you can make from a specific interpretive insight. Don’t stretch this range to where it can’t go. Identify where specific insights have different implications that can be made. For example:

  • If modeling a timeseries can produce x and y implications and modeling fundamentals can produce x and f implications, structure these implications correctly. Don’t use the timeseries model to find implication f and don’t use the fundamental model to find implication y. Just because both models can produce x doesn’t mean it has the capacity to produce an implication from a different model.

Bitcoin Float and Characteristics:

Fundamentally, every asset has supply and demand dynamics. When breaking down the drivers, we need to identify which ones are on the demand and supply sides. While many Bitcoin maxis point to the fact that there is a limited supply of Bitcoin, this doesn’t necessarily imply a specific outcome for the price unless you have certainty about demand (which we don’t).

In the same way, any asset has an outstanding float, tradable float, and average daily volume, Bitcoin is the same as any equity, bond, or security in this sense. Bitcoin does have inelasticity in the float given how the outstanding float and tradable float function. This inelasticity is simply due to the float characteristics and how centralized exchanges exist as liquidity provision funnels.

Finally, there is a clear absence of underlying cash flows for Bitcoin. Bitcoin continues to be driven by macro liquidity factors as opposed to factors related to transactions for goods and services being run through it. While many proponents of Bitcoin say it is a currency that will be used for everyone to transact goods and services, there is a clear lack of this having any significant impact on the tradable float.

Many data providers such as Glassnode provide data for the underlying transactions in Bitcoin. In my analysis and testing of these types of “fundamental” data points, they do not provide enough predictive or even explanatory value that would assist in conducting an attribution analysis for Bitcoin (obviously this could change in the future). Furthermore, these types of data points have incredibly low predictability for the price of Bitcoin.

Main Points:

• Bitcoin has a limited supply

• Transactions for goods and services are not being run on Bitcoin to the extent that it would constrain the supply. An example for this is comparing Bitcoin to the attribution function we conduct in equities. An equity has an earnings component and a valuation component. This is how we would quantify a view in connection to the supply and demand forces impacting the tradable float. Since Bitcoin doesn’t have clear underlying transactions for goods and services being run on it that would constrain the tradable float enough to be a significant factor in the movement of the price, it is primarily the valuation side moving the price of Bitcoin. While we technically would need some type of cash flow number to calculate a valuation ratio (for example a P/E, P/S or P/B ratio), we can still compare Bitcoin to how macro liquidity is functioning within the system as a whole.

See the research articles here for more of a breakdown of how equities and the microstructure of assets function:

Bitcoin Drivers:

The context above brings us to the actual drivers of Bitcoin. However, there are several qualifications that need to be made.

• First, Bitcoin clearly functions in a manner comparable to gold in its price action. However,. there is no evidence that implies this is guaranteed to persist in the future. Many investment professionals have accepted it as a type of asset that functions as a hedge or store of value. This can change at any time if the perception surrounding Bitcoin shifts. For example, if inequality in the United States decreased and the populistic narrative subsided, there would likely be significantly less demand for an asset that was “protecting people” (though there is no evidence that Bitcoin provides any more protection against inequality than any other financial asset) from “currency devaluation.” I put these in air quotes because no one who proposes these arguments as the use case for Bitcoin defines them with any rigor.

• Second, since Bitcoin doesn’t have intrinsic underlying cash flows or a specific external liability exerted onto it constraining people to buy it (such as the US dollar does with taxes), we can not have a conventional valuation metric. As a result, the primary driver of the price of Bitcoin is macro liquidity in a similar way it does with gold. This is true conceptually and also in price.

There have been a number of assumptions I have made here in terms of macro liquidity and also the actual attribution of Bitcoin. While I will explain the logic and evidence of how these assumptions work and connect with price action, going through extensive data analysis on all of these variables is outside the scope of this report. However, it will be incredibly clear that this is a coherent explanation accounting for the price action of Bitcoin.

Several Main Ideas: I am going to start with the data points and “give you the answers” so that I can backtrack and show you how they formulate together into a complete picture.

Let’s jump right in…..

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Bitcoin is driven by macro liquidity and is functionally a “liquidity release valve.” This is clearly reflected in the price action regardless of the narratives about the underlying validity or future outcome of Bitcoin as an asset.

Macro liquidity can be broken down into two components: The quantity of money and the price of money. The price of money is functionally the rate complex we see in nominal rates, breakevens, and real rates. Bitcoin has a very high beta to real rates and the real rates curve historically. If you decompose the nominal curve into regimes (bull/bear steepener/flattener), this will provide further visibility into the “price of money.” The quantity of money is more complicated but is directly connected to the quantity of base money in the financial system. For example, we can see that the fall in real rates (blue) and increase in central bank reserves (white) during 2021 were both creating a positive liquidity impulse. The large momentum impulses to the upside in Bitcoin during 2020 and 2021 were a direct reflection of this. There is NO evidence that Bitcoin established any safe haven qualities or currency qualities where it could be used as a medium of exchange during this time. While narratives might say this is possible or can occur, there is no evidence that the market believes this enough for the actual price to be driven by it.

If Bitcoin was used as a medium of exchange as its price went up during 2021, then it would have maintained a significant bid during the increase in nominal activity during 2022. Instead, Bitcoin fell as liquidity contracted and valuation multiples in equities fell.

A key thing to make note of is Bitcoin (and gold) has diverged from real rates during 2023 and 2024. The reason for this is that the quantity of money is creating a greater positive liquidity impulse than the negative impulse real rates are causing. This divergence between the price and quantity of money is covered in this interview incredibly well:

So, to summarize really fast, Bitcoin is primarily driven by macro liquidity. The way to understand macro liquidity is how the price of money and quantity of money interact with each other to create a “net impulse.” This net impulse is what impacts ALL financial assets across the risk curve. If you quantify the rate complex and quantity of money, then you’ll begin to have a clear understanding of macro liquidity.

Check out

Prometheus Research

and

Concoda

for the quantity of money side.

Prometheus has a great article on liquidity here: https://prometheus-research.com/monitoring-liquidity-dynamics/

Concoda

has primers on the entire plumping of the system: https://www.concoda.com/s/primers (for those who are wondering, yes it is Zoltan)

Pull It Together:

Now here is where it gets tricky but this is where the magic happens. One of the reasons my BTC strategy does well (trade example: link) is that I map how growth, inflation, and liquidity are impacting ALL assets. Bitcoin is an asset on the risk curve like everything else. Anyone who tells you Bitcoin isn’t part of the financial system or doesn’t fall on the risk curve is missing the fact that Bitcoin is priced in dollars.

This was pretty funny:)

Since Bitcoin is primarily a liquidity release valve, if you are watching all of the equity sectors and factors across the risk curve in their earnings and valuation components, then you have a super clear read on how ALL risk premias are functioning. When you have large FX moves that are in confluence with factors in both countries, many times these FX and cross-country factor moves will be in lockstep with BTC flows. For example, watching how USDJPY moves in connection with equity factors in Japan and US markets. When equities on the far end of the risk curve have valuation expansion, Bitcoin is likely to rally.

So to sum up, have a view on macro liquidity (price and quantity), have clear visibility into how growth, inflation and liquidity are impacting ALL assets across the risk curve and then map the correlation of Bitcoin to all of the lead and lags of these various assets. The goal is to triangulate flows in how they drive all risk flows across the curve instead of just being siloed in on Bitcoin alone.

Within this we have positioning:

After you frame the points above, you have basic positioning dynamics. For example, you can have additional sources of flows like an ETF or liquidations across exchanges. Typically speaking, these types of positioning dynamics will occur within a certain standard deviation range before the macro regime exerts its constraints. If you are getting the macro side of things right, the moves in short-term positioning moves will become A LOT clearer.

Finally, we need to connect things to the regime we have in price. If you have followed me for any period of time, you know my emphasis on momentum and mean reversion. Check out these articles on how to model this:

• The Research HUB: Regime Alignment

• The Research Hub: Risk On / Risk Off Regimes

Fundamentally, you want to match the moves you are quantifying on the macro side with momentum and mean reversion in the price. For example, if we are having a significant positive liquidity impulse, you want to be running a bullish momentum strategy. You can also run a buy-the-dip mean reversion strategy within this bullish momentum strategy.

For example, you can begin connecting technical momentum signals to how your macro view is working out. During this first top in 2021, ARKK actually topped first as the real rate curve begin to fall. This also occurred as the dollar was bottoming and the ISM was topping.

See the articles I noted above because I reference specific Tradingview scripts in them that I would encourage you to check out. While I have built my own proprietary models for quantifying price, having an MA crossover, ATR, momentum strategy and Bollinger band strategy will get you pretty far.

Bitcoin Strategy:

Alright, so you finally are at the end. Now we stack logic.

Let’s say you don’t know any code and failed pre-algebra like me (ironic but I made up for my past failures :) ). Not a problem, we can still make tons of money by being rigorous and precise.

You start stacking IF THEN clauses that screen for logic and thereby produce signals. Let me give a simple example:

• IF macro liquidity = positive THEN trigger bullish. IF macro liquidity = negative THEN triggers bearish. (we won’t get into a neutral regime here but you can categorize regimes by strength in a similar way you might categorize growth strength with a diffusion index)

  • IF bullish THEN turn on the bullish MA strategy with x lookback.

  • IF bearish THEN turn on the bearish MA strategy with x lookback.

You can begin to optimize stop-loss placement by determining the current volatility of the price. Your stop is simply going to be a function of your signal-to-noise analysis (where can I place my stop to have the best R:R while also balancing the variance that the price can have without falsifying my view).

Mean reversion is a lot trickier in any asset so if you are new, just focus on momentum and catching the big moves.

The Goal:

Everything I have shared is literally the baseline that any high-level crypto trader at a hedge fund has. There are PMs at hedge funds in the crypto space are complete savages and optimize for WAY more stuff than I noted in the article. However, this is the overall context to operate in.

Once you begin to frame the macro side correctly and map how BTC fits into the overall risk curve, you will begin to recognize there are a lot of additional ways to generate signals. This allows you to understand the actual price more instead of relying on artificial “support” levels.

Like I said previously (link):

I provided a breakdown of my current views on Bitcoin here:

Conclusion:

If this felt like a lot, good! There are a lot of ways to generate alpha and we live in a time where it all comes down to your ability to think clearly about the world.

We will continue to move forward together on the Substack! I will be providing more analysis on the rate complex and how it frames the liquidity picture into the end of 2024. If you aren’t a paid Subscriber, I would encourage you to try the free trial. I can guarantee you that the intensity at which analysis is provided won’t slow down and the alpha sharing won’t stop!