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Economic Cycle & Business Cycle

Economics and Currency

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GDP typically rises and falls in a pattern associated with the “economic cycle”, also called the “business cycle”. “Expansions” in the business cycle increase GDP, and it eventually tops out in a “Peak”. After the peak comes “Contractions” and GDP growth rates fall. When the contraction stops, a “Trough” forms and the economy “Bottoms out”. This is the lowest point in the business cycle. After the bottom, the economy enters the “Recovery” phase and begins to expand again. Be sure not to confuse pauses or dips in GDP uptrends with the business cycle contracting. Generally:

Asset ClassTroughExpansionsPeaksRecessions
InflationLowestRisesHighestFalls
GDP OutputLowestIncreasesHighestFalls
Interest RatesLowestSlowly IncreasedHighestLowered
Equities and IndexesRise in ValueRise in ValueFall in ValueFall in Value
Investment Grade BondsRise in ValueRise in ValueFall in ValueFall in Value
Junk Grade  BondsRise in ValueRise in ValueFall in ValueFall in Value
CommoditiesFall in ValueRise in ValueRise In ValueFall in Value

 

The following will guide you through the Economic Cycle in detail, starting with the bottom of the economic cycle. Remember that pinpointing exactly where you are in the cycle is difficult. There are always signs, but since economic cycles vary in length and signals exhibited, pinpointing the economy’s transition point is not always easy.

Trough

Let’s start with the bottom of the economic cycle. The trough is the bottom and lowest point in an economic cycle, and occurs after a recession. In terms of decline and losses, the worst has already occurred but this isn’t necessarily known by market participants.

The central bank has already lowered interest rates to their lowest in the economic cycle (and possibly the lowest they’ve been in decades). Rates were lowered to encourage corporate, consumer, and government borrowers to use loans to increase spending on products, services, labor, assets, and real estate. When someone spends, others earn income and profits from their spending. If the borrowers spend and borrow to spend, the economy will get a jump start from their spending.

Debt is very low as a total percentage of the assets in economy. Note that this is consumer, corporate, and mortgage debt to GDP and NOT the Federal Government’s debt to GDP. Interest payments as a percentage of Gross Domestic Product are also fairly low. This economy is fairly deleveraged, as banks and companies with high amounts of debt likely went into bankruptcy or defaulted during the prior recession.

Stock markets are at their lowest value, due to losses or low profits encountered during the recession. Falling spending and credit freezes hindered stockholder’s businesses. As signs of recovery roll in, traders will want to purchase stocks to acquire strong returns at cheap prices. Short sales should be closed and watch-list for purchases of fundamentally strong stock should be created. As the watch-list of stocks rises, traders will buy into the rising trends.

Commodity markets are also be at their lowest. During recessions, spending slows as credit markets seize up and borrowers/spenders already have high debt loads. Instead of shopping, they must repay their existing debts. Additionally, falling profit resulted in companies laying off workers, resulting in less income for workers to use in spending. Lower sales leave supplies of commodities stockpiling in inventory, and prices fall. As the economy recovers, commodity stockpiles will decrease, and then prices for commodities will rise over time. Traders will want to purchase commodities strongly correlated with economic expansion while they are inexpensive.

Recovery

During the economic recovery, the destabilization that created or occurred during the recession and the fall in GDP begins to reverse. Since central banks have no reason to increase the interest rate, rates are still low. However, borrowers have begun to come to the table. Banks are willing to lend since they believe the worst is over. Lending accelerates.

As lending rises in the economy, total debt levels and interest costs as a percentage of gross domestic product increase. Initially, debt and interest costs are very low respective to total incomes, so borrowers still have the ability to repay. Banks are happy to lend since debt levels are low relative to assets, and might even lower credit standards to facilitate more borrowing. This borrowing is typically used in productive ways, so economic productivity increases. This results in Gross Domestic Product expansions, alongside increases in middle and working-class incomes.

Borrowing is also used to drive consumer spending and profits begin to rise for corporations. Leverage to purchase investment assets is happily extended in the forms of mortgage and brokerage lending. As a result, real estate and asset prices also rise. Traders will want to continue buying stocks as the prices rise, and purchase real estate to take advantage of low prices relative to future price increases.

All this spending results in prices rising over time, also called inflation. Spenders consistently purchase goods/services created from the manipulation of raw materials. In turn, the producers of these goods/services must buy more commodities, to create more products. Producers are bidding against other producers in a competition to buy the same commodities. The bidding war creates inflation, alongside printing of money by central banks. The printing of new money increases money accessible in the economy for lending and spending, helping to accelerate the increase.

Over time inflation will need to be curbed by central banks, who will raise rates when they believe inflation is getting out of control. Traders will want to take profit on long bond trades, since bonds will fall in value when the central banks eventually raise interest rates. Traders will want to continue buying and holding commodities, as they will increase over time due to the bidding war that occurs during productivity expansion.

Expansion

When economic expansion occurs, the economy has expanded beyond the peak of the prior economic cycle. Economic productivity, measured by GDP, should now be higher than any point in the prior cycle. During this stage, trends in the recovery stage continue but are more mature.

Lending has continued to rise. By this point the amount of debt to assets is approaching or post higher than long term average levels. Interest costs as a percentage of income also rise. Costs may be higher than average or potentially most of incomes. Credit standards are still low, and borrowing is used in irresponsible ways or methods. Refinancing (using new loans to pay off the balance of old loans to delay repayment) will be increasingly common. This is essentially kicking the can down the road. The debt must be paid eventually. As central banks raise rates, those refinancing may be problematically borrowing at higher rates to pay loans at lower rates.

Profits and incomes continue to rise, but debt levels and interest costs are slowing down expansion. Purchases of assets have continued, and a bubble is potentially forming due to over-extension of asset purchases. Price to Earnings of stocks in the market will be increasingly high, and real estate prices will become increasing ludicrously overpriced. But increases in stock and real estate prices increase the amount of collateral that borrowers can show banks. This increases their ability to borrow. This borrowing has two uses. It is either invested and inflates prices further but gives more collateral. Alternatively, borrowed money is spent unproductively. Either way creates higher debt levels and debt service costs. This cycle can create a lending bubble if it continues indefinitely. The bigger the bubble becomes the worst the next recession will be for the economy. Traders will continue holding stocks, but become increasingly nervous about the possibility of being caught holding overvalued equities if the market turns south. Some will reduce exposure as the cycle matures.

Due to the continuation of borrowing for spending and borrowing for productivity, the bidding war for commodities used in production heats up. Central banks eventually become aware of inflation, and will consider raising interest rates. In a bid to get control and limit inflation, slow rate raises will incrementally occur, usually either a quarter or a half percent at a time. As rates rise, the cost to borrow will rise, and the incentive to refinance loans or spend on consumption will disappear due to high interest costs. This will slow, then eventually kill, the growth of the asset bubbles which relied on easy access to credit. Traders will avoid holding bonds as interest rates increase, and might short bonds as the central banks raise interest rates over time. Traders will also continue holding commodities, but be prepared to start taking profits if they see the economy starting to peak to avoid getting caught holding the bag during the downturn.

Peak

During the peak, bubbles become obvious to those paying attention, but the vast majority of market participants are sleepwalking. Most factors are identifiable in terms of seemingly illogical stock prices or real estate valuations. The economy also has high debt levels relative to assets, high interest costs relative to income, rising interest rate levels, and possibly inverted yield curves. Note that inverted yield curves are a market signal that the end is near. Within 24 to 36 months, a recession has always followed an inverted yield curve. Note that every recession does not always have an inverted yield curve before it occurs.

Interest costs are extremely high. An extended period of borrowing has resulting in large amounts of interest charged relative to incomes and the long-term average. These interest costs drag down spending and interest rate increases will eventually push costs over the edge of sustainability. When interest costs eat too deeply into incomes, spending falls and the downturn will begin.

Credit standards rise as banks become aware of how much debt exists in the economy. Debt levels relative to asset levels are higher than any other point in the economic cycle, but now the ability to acquire debt is slowing. As debt availability slows, spending slows, which weakens economic stability and makes GDP more likely to contract. A rise in credit standards also slows real estate and leveraged investing, making those markets more likely to decrease from lack of credit market support.

Simultaneously, high interest rates slow economic participants willingness to borrow. As rates rise, borrowing becomes far more undesirable. Real estate, investment, and consumer/consumption spending slow as demand for credit disappears. Interest rate increases have already pushed bond values to their lowest point in the cycle. Bond yields are high, and potentially inverted.

Asset prices, including stock markets, are massively overvalued after years of debt driven purchases. Commodity prices, also driven by years of economic expansion are also extremely high. Eventually, these markets will crash due to the combination of exaggerated valuations, high existing interest costs, high existing debt levels, and high interest rates.

Traders will take profit on stocks, cycling into cash. Traders will also take profits on productivity related commodities. They expect the cycle to come to an end and will wait until they can buy for cheap during the trough or economic recovery. Some astute traders might even short the decline, but this can be dangerous. They won’t be sure if the decline is a dip in the market or the actual downturn until later.

Recession/Depression

Recessions and depressions are the most feared aspect of the economic cycle. During this stage, layoffs are high, spending is low, and loans offered at a reasonable level are hard to find.

Debt levels relative to assets are high, but steadily falling due either to repayment or default. Refinancing is typically less available than normal. Interest payments as a percentage of income are high, but falling alongside debt levels. Since both categories are falling as a result of repayment or debt default, spending is low. New investment created by utilizing debt or borrowing is also low. Fresh investment falls through the recession, and bottom out during the trough.

Due to a lack of spending and high interest payments, profits also fall. The fall in profits results in an inability to support existing business costs. Corporations and small businesses begin to lay off employees to decrease expenses, killing working class spending to avoid bankruptcy. Equity and commodity markets fall, scared by the decrease in profits during the downturn and possible freezing of credit markets. Traders either sell out late, hold at increasing losses, or increase short positions in equities and commodities for a profit.

Interest Rates are lowered to stimulate the economy. The decrease in interest rates allow bonds issued at higher rates to increase in value, since new bonds will pay less. These existing bonds are purchased, bidding up their price and bond yields fall. Traders remain long bonds, anticipating one or many sequential interest rate decreases.

Commodity Price Shocks

Commodity Price shocks can also create recessions. A price shock upwards can drive economies dependent on the import of a commodity into recession. If the price of a primary import skyrockets, the nation may suddenly find itself forced to budget more towards the purchase price of the commodity, and unable to spend or invest elsewhere. The higher cost economically strangles the nation’s productivity and forces the nation to sell domestic currency to import the foreign good. The increase amount of currency sold can result in an unexpected bump in inflation.

An economy driven by exporting a major commodity will suffer greatly if the price of that commodity heavily falls, due to a lack of demand or excess supply. The loss of income results in companies primarily driving that economy being unable to pay their debts and costs. This results in layoffs and bankruptcies. The nation can no longer acquire tax revenue from business profits. A fall in any key export’s demand will also have the same effect, even if it’s not a commodity. The government will suffer lost tax revenues for the nation. They incur deficits and must borrow capital to balance their budgets.

Foreign Debts and Inflation

Due to commodity price shocks or possibly due to a recession, if a nation’s debts are held in a foreign currency, high inflation may follow. The domestic currency must be sold to repay interest costs. If there is no buying demand for the domestic currency created by the nation’s exports or investments to cancel out the currency selloff, these sales can create hyperinflation. This hyperinflation will eventually destroy the economy.

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