The financial news is full of discussions about economic cycles: booms, busts, recessions, depressions, peaks, troughs and so much more.
These discussions often leave the average investor wondering what it all means and is it all really that important?
Economic cycles are so prevalent in the financial news and literature because they are so central to everything that happens in the markets and economy.
Let’s take a brief look at what economic cycles are and why they are so important to your trading.
The Boom and Bust of Economic Cycles
While there may be some disagreement on the exact details involved, mainstream economics is based on the business cycle theory.
The business cycle theory suggests that whether an economy is expanding, contracting or stagnant in the long term, in the short term it will follow a natural cycle of booms and busts.
Therefore, economic activity may increase at an average rate of 4% per year over 10 years, but in those 10 years the actual annual rates of growth will vary widely.
This means that an economy is always somewhere on the current business cycle, and the location on the economic cycle will determine the nature of the economy at that time.
If the economy is currently in the early stages of the boom cycle, then investment and consumption will be slowly expanding from recent lows. By contrast, an economy at the bottom of a bust cycle will have low levels of economic activity and high unemployment.
At the core of economic cycles is the idea that people tend to overreact to both good and bad economic environments, so that booms always crash from their extreme peaks and busts always rebound from their extreme troughs.
Everyone who is economically active, from CEOs to waiters, has an interest in the current state of the economic cycle. When the economy is expanding rapidly, people are more willing to invest and consume, while people will be more conservative and spendthrift during economic downturns.
Economic Cycles and Fiscal and Monetary Policy
While economic cycles are largely driven by the billions of undirected individual decisions that take place in an economy, there is one economic actor that has a major influence on the economic cycle: governments.
By controlling both monetary policy (the creation of money and the setting of interest rates) and fiscal policy (government spending and taxation), governments can influence the general shape of the economic cycle, though they cannot control it outright.
Therefore, while people take the economic activity of individuals in the economic cycle as a given, there is much debate about what governments should or should not be doing during various stages of the economic cycle.
Monetary policy is generally counter-cyclical, as the central bank raises interest rates to cool investment and reduce consumer spending by increasing the cost of borrowing.
Monetary policy in effect ‘smooths’ the extremes of the economic cycle by dampening excessive spending during booms and stimulating stagnant spending during busts.
Fiscal policy is also best practiced counter-cyclically, but the track record for governments is much poorer than for central banks. Many governments see the revenues generated from economic booms as an opportunity to increase spending and cut taxes to win votes, which only enhances the current economic expansion to extremes.
Similarly, governments tend to impose austerity when the economy is already in a recession, which can further dampen economic activity.
Economic Cycles and Trading
While economic cycles offer little in the way of directly actionable trades, they form the backdrop for all trading activity across every asset class.
However, high-yield corporate bonds and counter-cyclical equities are but two examples among the many assets whose value moves opposite to their general asset class with respect to economic cycles.
Day traders of every stripe should be in the habit of tracking the progress of the current economic cycle and any proposed government action in response.
Being able to forecast economic activity and government actions offers day traders a holistic and comprehensive insight into the general movement of all asset classes, which is a favorable perspective from which to approach the generation of individual trades.