Liquidity Cycles and Asset Prices

Behind every price is a question of how much money is looking for a home. When money is plentiful and cheap, it flows into assets, including the riskiest ones. When it is scarce and expensive, it flows out, starting with the riskiest. This ebb and flow is often called the liquidity cycle, and it is one of the strongest forces behind the long moves in indices, crypto and gold.

Where liquidity comes from

Central banks create the base of the money supply through their policy rate and their bond purchases. Commercial banks multiply it by lending. Governments add to it through deficits. Foreign flows bring it across borders. When all of these are expanding together, markets tend to rise broadly, regardless of the news. When they contract together, rallies struggle to hold.

The order of effects

Liquidity reaches assets in a rough order. Government bonds respond first, because they are the direct target of policy. Large-cap equity indices follow. Technology-heavy indices and crypto, which depend most on cheap money and future hopes, respond most strongly in both directions. Gold responds to the real yield that liquidity conditions produce.

This ordering is why crypto and technology indices often move together and why both tend to lead the broader market at turning points.

Reading the cycle

A trader does not need a model of the money supply. A few indicators serve well:

• The direction of central bank balance sheets
• Short-term interest rates relative to inflation
• The ease of corporate borrowing, visible in credit spreads
• Whether the most speculative assets are leading or lagging

When speculative assets lead to the upside, liquidity is expanding. When they lead to the downside, it is contracting, even if the headlines say otherwise.

Implications for strategy

In expanding liquidity, buying pullbacks in strong trends works well and patience is rewarded. In contracting liquidity, selling rallies works better and quick profits are wise. A strategy that thrived in one phase may need smaller size, or a rest, in the other. Checking the phase once a month is enough.

What to watch

Watch the combined direction of central bank balance sheets, the relative performance of crypto and technology indices against the broad market, and credit spreads. A change in the leaders usually comes before a change in the headlines.