The Economic Cycle, also known as a business cycle, refers to fluctuations in the economy between periods of expansion and contraction. Factors and indicators such as Gross Domestic Product, Employment and Consumer Confidence can help to determine the current stage of the economic cycle. See our Wiki on Economic Data for more indicator-specific information.
Understanding the economic cycle can help traders, investors and businesses determine when to make investments and when to put their money on the sidelines, as it can have a direct impact on the performance of stocks, bond, commodities and even Forex.
In this Wiki, we will explore the various aspects of the Economic Cycle and how you can know where we are within that cycle.
State of the Economy
Let’s pretend for a minute that you are a wealthy investor who is looking to not only protect your wealth but also grow it at a decent rate of return. Given that you have plenty of money what would you do and what would you invest in? When you have lots of money your primary concern is to preserve that money rather than growing it aggressively. Of course, you want the best possible return on investment but the primary focus typically shifts to wealth preservation.
Or imagine that you are responsible for allocating capital for a large pension fund with exactly the same goal in mind to protect and grow the wealth of your clients. You would no doubt want to place your capital in some place that is politically stable, has good growth potential, and has a high level of interest payout. This would be the perfect scenario with low risk and high reward. It’s for reasons like this that interest rates are so important to the FX markets.
There are literally trillions of dollars floating around in large funds, banks, and wealthy investors’ portfolios all looking to do the same thing, preserve capital and get a decent rate of return. So it makes sense that we as traders would probably want to know what these big money players are doing and why so that we can pick up some nice trading opportunities along the way.
Investors from all over the world are looking for places with political and economic stability but also offer higher rates of interest to help their money grow. This is why these big investors watch the FX market very closely for any signs of politically stable countries that might start raising their interest rates soon. When they do find this combination of economic stability and potentially higher interest rates there is a flood of excitement and demand rushes into the FX market as investors try to get their funds into these countries’ currencies early to take advantage of, not only the higher rate of interest, but also the increasing valuation of the currency due to more people buying the currency up.
For example, if a Japanese pension fund wants to invest in the UK then they have to first purchase British Pounds which has a direct effect on the value of both the Pound and the Yen. As more outside investors come in the value of the Pound currency goes up. It will likely continue to go up over the long run until the UK economy is no longer attractive and the cycle turns around the opposite way again.
Traders like us know that this will happen and when an economic cycle looks like it's improving traders will try and get in on the expected increase by buying the currency ahead of the larger investors. Remember, we provide the liquidity to the markets that these large investors need so we are not getting a free ride.
We are also lighter and more nimble when it comes to getting into the market quickly which is one of our competitive advantages that large funds do not have. Think about that; if we buy a lot or two the market won’t even blink but when large funds are coming in looking to buy tens of thousands of lots they are going to have an impact on the particular currency pair.
It may take a large fund several days or weeks to make decisions and process its transactions before converting its huge capital. By this time we are already in and riding that wave up, and sometimes several times already.
This means that there are 2 distinct waves to look out for:
- The first wave is the reaction wave and this is generally speculators trying to beat the larger players into the position.
- Over time comes the larger secondary wave that is caused by the reallocation of large investments into the particular currency of interest.
Knowing this information is one of the main reasons that economic cycles are so important in predicting interest rates. It’s also why interest rates are so important to predict the moves that the larger players in the markets will make and want to be a part of. This is the type of information and trading opportunity that speculators live to take advantage of. Make sure to commit this to memory because potential higher interest rates in stable economies can reap a lot of very easy trading profits if you understand how this all works.
One of the most important concepts in FX is that of inflation and deflation because Central Banks almost always have this as a primary focus for how they are going to manage their respective economy. In this Wiki, we will explore:
Economies run around economic cycles of varying degrees. In this Wiki, we are going to take a look at how economic cycles revolve around the 4 phases including:
Economic Data and Economic Cycles
It’s important to view economic data developments in the context of trends and cycles. What does this mean?
The trend is the long-term rate of economic expansion within an economy. So, if we have a situation where a particular data set has been coming out really positive 9 months in a row then we can confidently say that one bad number does not change the overall positive trend. 9 positive readings out of 10 makes for a very positive trend and the one bad reading could be dismissed as long as more poor readings don't keep happening.
Industrialized economies tend to have growth trends that can last decades so traders don’t need to change their entire opinion of the fundamental situation of an economy just because one bad number came out the previous month.
The cycle represents short-term fluctuations around the trend and that too can provide some nice trading opportunities.
The Economic Cycle Revisited
Since we have made mention of the cycle it is perhaps a good point to give you a simplified explanation of what it actually is so that you can better understand how it functions in relation to economic data.
There are 4 stages of cyclical activity in the business cycle:
- Expansion: This is a time when demand first increases and then starts to gather momentum. This demand creates jobs and new employment which then creates more demand for consumer goods and housing. This is because more people have good paying jobs and more disposable income. This is the time when people are most secure with their job and spending their money. Policymakers love this part of the business cycle.
- Peak: The earlier momentum from the expansion phase cannot continue forever and at some point, it has to top out. Interest rates typically rise near the peak because of the prolonged good economic conditions from the previous expansion. Interest rates go up because inflation is at or has breached the central bank's mandate and they need to slow it down. These higher interest rates are at times arguably what causes the next part of the cycle.
- Recession: Demand starts falling which causes producers of consumer goods to start cutting back on labour in an effort to remain profitable. This cutting back of the labour force starts to show up negatively in the unemployment statistics. Unemployment starts to rise and this, in turn, reduces consumer demand because fewer people have jobs, and as a consequence have less disposable income. Policymakers want this phase to be as short as possible so that the economy can get back to growing again.
- Trough: At some point just as the economic situation looks the worst the total economic output will find a bottom and stop falling. The central bank will typically start cutting interest rates with the hope that businesses will borrow money and invest in new projects. The idea is that this will create new jobs and stimulate demand for consumer goods as well. The point is to get out of the trough and back into the expansion phase quickly.
In this Wiki, we are going to build on Economic Cycles by diving into the various indicators that are within the Economic Cycle including:
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