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19 - The 4 Phases of the Economic Cycle
Chilli chilli bang bang! Welcome to the first lesson of the third section in this guide to understanding trading with fundamentals and sentiment in the Forex market. In this lesson we will take a look at the economic cycle and its various phases. The economic cycle should actually be a part of fundamentals but we thought that it was important enough to give it its own section here. So let’s go.
In this Article:
- Introducing Economic Cycles
Introducing Economic Cycles
There are 4 phases to an economic cycle. These phases are called the expansion, peak, recession, and trough. You will find that different text books refer to each of these phases with slightly different names. However, the important thing to understand is that the economy goes up, tops out, goes down, and then bottoms out.
The economic cycle is the natural fluctuation of the economy between periods of expansion (growing) and contraction (umm, not growing). This happens for a whole host of different reasons. Factors such as gross domestic product, interest rates, the employment situation, and consumer spending can help give us clues as to what current stage of the economic cycle that we are in.
Let’s take a deeper look at each of these individual phases now.
For most major economies the expansion phase is when consumer purchasing is growing and positively contributing to GDP numbers. This is especially true for consumer spending purchases of big ticket items such as houses, appliances and cars. Think of things such as durable goods which are expensive and have a long usable lifespan.
In general, interest rates will be relatively low at the beginning of the expansion phase because of the low levels of economic activity in the preceding phase. However, they typically rise as the economy starts to heat up grow.
The central bank will eventually need to step in and attempt to keep inflation from getting too high. Inflation doesn’t get too high at the beginning, it tends to peak out near the end of an expansion phase.
Stocks that perform well during the expansion include technology, durable goods producers, luxury producers, and cyclical industries that need strong economic activity to pull larger profits. Think of things that people would only buy if they had extra money. People tend to have extra money when the times are good.
However, just a rising tide tends to raise all boats in the harbour; the same is typically true of the stock market as well. Most stocks will perform well except those that are fundamentally broken and have real reasons to perform poorly.
The currency tends to strengthen during the expansion phase as the smart money traders anticipate economic prosperity and potentially higher rates of interest to come. The name of the game is to get in on an expanding economy as soon as possible and the currency is one of the best ways to do that.
The currency tends to go up for a few reasons:
- Speculation: Remember that we are all speculators and hunting for a profit is our game. Getting in as early as possible is a good way to increase gains.
- To gain a higher yield on investment for large funds such as pension funds or asset management firms. Remember that a high interest rate in a stable economy is one of the most desirable situations a large asset management firm could ask for.
- Economies that are performing well tend to attract foreign investment. Over time, this strengthens the local currency and increases the rate of expansion within the economy. If money is flowing into the country then this means the demand has risen for the currency….prices go up.
Once the expansion is under way the economy will eventually get to a point where it will peak in economic output and productivity. Things just can’t go up forever and there is a natural rate that most economies can grow.
At this point businesses within the economy are thriving. However, they are now facing new cost pressures that they were not at the beginning of the expansion phase. Employment costs typically go up as the labour market becomes highly competitive so that companies and produce and sell more of the stuff they make. The price of skilled labour tends to go up quite a lot.
Added to that, interest rates typically start to climb because investors and central banks are concerned about the risk of rising inflation. This puts even more cost pressure on companies because it costs more to borrow money to continue expanding their operations.
Rising interest rates start to make new homes less affordable for many consumers who are just getting to the point where they can potentially qualify to borrow. Typically, rising interest rates tend to put a lot of pressure on people classed as middle class or lower. Less new home purchases causes layoffs in the housing sector and other interest rate sensitive sections of the economy.
The stock market is a discounting mechanism (as is Forex) and tries to anticipate economic peaks 3-6 months in advance. The major indexes are almost always declining by the time that the economic indicators prove the peak has arrived. This is because most economic indicators of importance are lagging by nature. Think of GDP for example, this doesn’t change in real time; it’s a slow process that develops over time. But, there are a few indicators that are used to predict economic turns as we have discussed in previous lessons.
The currency starts to top out as traders try and anticipate the start of the next phase of a recession. Almost all recessions lead to interest rate cuts by the central bank as they attempt to get the economy back on track by stimulating borrowing and spending.
Early in this period sales on items such as cars and kitchen appliances begin to fall. This causes the companies that manufacture these products to cut back on production. Because manufacturers are producing fewer products they have no choice but to lay off employees because they are no longer financially competitive.
If companies want to survive the recession they must reduce costs any way they can which typically starts with letting go employees. Employees are the easiest cost to reduce so we will tend to see the employment numbers decline or turn negative fairly early in this phase.
When unemployment starts to rise this means that personal incomes within households start to fall. Obviously, if more people are losing their jobs then more people will have less money. This goes back to the point that companies need to cut costs to remain in business.
Interest rates are generally higher at the beginning of a recession but fall quickly throughout the recession as the central bank attempts to get the economy back on track. By cutting interest rates the central bank is basically trying to incentivize companies to invest in capital expansion projects with lower interest rates. The idea is that if the cost of money goes down then this could make new projects financially viable. If companies are incentivized to expand this means that they will hire more people which we know is incredibly important for a healthy economy.
Most stocks and indexes perform poorly during a recession because company profits start to fall or turn negative. However stocks of consumer staple companies such as those that produce food, beverages, household personal care products, pharmaceuticals, utilities, and dividend paying companies often hold their value fairly well. This is because these firms sell goods and services that people need or must have even when economic times are tough. People might cut back on luxury products but they still need to have food, shelter and electricity to survive. The companies that sell that type of stuff tend to hold their values much better than those that do not.
The currency will typically drop or selloff as the market begins to anticipate how low the interest rate will be cut to. The market will basically try and discover what the new fair value of the currency should be. Things tend to selloff much faster than they rise so it’s very common to see prices overshoot to the downside as a lot of momentum can move things further than is reasonable. Finding a bottom is typically a very volatile process.
Speculation about what the central bank will do next is always at the front of the markets mind in any economic phase but in a recession this speculation can really ramp up to epic proportions. This is because if a market is fearful or concerned then the speed at which money moves into and out of assets increases quite a lot. Preservation of capital is the name of the game in a recession. This is called a “Risk Off” environment that we will devote an entire lesson to in the sentiment section of this course.
At some point the central bank will be forced to combat the recession. And you guessed it; the market will try and anticipate the central banks actions ahead of time. This is exactly the type of thing that we will be doing as well. This also highlights why understanding the expectations of the market is probably more important than what actually happens because major price moves are created by the speculation around what central banks will do next.
So far we have looked at the expansion, peak, and recession. Now we come to the trough which is the final phase of the economic cycle.
During an economic trough businesses have been punished enough that they just want to get rid of their inventory and try to get some cash on the balance sheet. They do this by lowering prices for big ticket products enough to start attracting bargain hunters to start buying again. A good deal is a good deal and this is where the best deals for the consumer will be found.
When enough companies lower their prices to attract buyers the economy starts to find its footing because consumer start departing with their money and buy stuff they may have been putting off for a while. This will help to bolster consumer spending numbers which as we know can be a leading indicator for which direction an economy is headed.
Sales of new homes often start to rise as qualified buyers can’t resist attractive home prices and low interest rate mortgages. That is what we all want when buying a home right? Cheap houses and low interest rates #YesPlease.
The stock market will start to anticipate good things to come by pricing in the coming economic expansion. We tend to see transportation stocks begin to rise because an economy needs more transportation vehicles to move around more goods that are starting to be produced. As manufacturing increases more goods need to be moved around and shipped.
Currency traders now try to predict the start of the expansion phase. Expansions typically mean that interest rates will start going up in the medium to long term as the economy heads back into an expansion phase. And we know how much the big asset managers love rising interest rates and a stable economy.
This time can be volatile for the currency prices as the market tries to find the fair value based on upcoming expectations. The market is still dealing with remembering how bad the recession was but once things start to improve optimism typically takes the place of fear and the economy starts to rock and roll.
The National Bureau of Economic Research in the United States is the definitive source of setting official dates for U.S. economic cycles. What they do is measure the length of economic cycles from trough to trough, or peak to peak by using changes in gross domestic product.
From the 1950s to the time of this writing in early 2018, U.S. economic cycles have lasted about 5.5 years. However, there is wide variation in the length of cycles, ranging from just 18 months during the peak to peak cycle in 1981-1982, up to 10 years as was the case from 1991 to 2001.
You can check out the cycles for yourself at http://www.nber.org/
The key to understanding the current economic situation is identifying when an economic expansion is over, when the peak has occurred, or when a new expansion is about to begin after the trough has occurred.
Although the periods of peak and trough can be relatively brief and difficult to pinpoint, understanding economic indicators can help you identify them. If you haven’t already, go check out the several lessons we did on economic indicators.
Now that we know all about the economic cycle we are going to look at and actually define and describe the things that happen within a cycle. Next we will take a look at inflation.