We will look deeply into these cycles and why are they important.
Central banks perfect scenario is where the economy is growing while their currency stays weak but this never happens because of the impact of various economic cycles.
First, we will look why a state of the economy is important and what role interest rates play in all of this.
Imagine you are the wealthy investor looking to protect and grow your wealth, what would you do?
Imagine you are responsible for a capital of large pension fund with exactly the same goal in mind.
You would want to place capital somewhere where is politically stable with good growth potential and with a high level of interest payouts.
This would be perfect scenario low risk - high reward.
This is why interest rates are so crucial in the FX markets, investors from over the world are looking for places with stability but higher rates of interest on money. So they watch the markets very closely
for any signs of any stable country will start to raise rates anytime soon, and when they do there is flood of excitement and demand as they try to get funds in this country early to take advantage of situation.
Example: if Japanese pension fund wants to invest in the UK then they have to first purchase Pounds wich of corse haves direct effect on the currency. As more investors come in the value of the currency rises and rises until the economy is no longer attractive and it turns again.
Traders like us know this will happen and when economic cycles become improving we try to get in on expected increase by buying the currency ahead of those investors.
Remember we provide the liquidity to the markets wich also means we are lighter and nimble when it comes to getting into the market quickly.
It may take a large fund several weeks to process the transactions and make decisions before converting their huge capital by wich point we are already in and riding the wave up.
This means there are 2 distinct ways to account for:
The first wave is the reaction wave and this are generally speculators try to beat the larger players in the position, and over time comes large secondary wave that is caused by those relocations in investments taking place.
This is one of the key reasons why economic cycles are so important in predicting interest rates and why interest rates are so important in predicting the moves of larger players.
This is the type of information and trading opportunity that speculators exist to take advantage from.
One of the most important concepts in FX is of corse Inflation and Deflation.
Central bank tries very hard to keep their prices rising but only gradually, if prices rise enough that encourages growth and spending because people know in the years time the thing they are considering buying will likely be more expensive so they may as well buy now.
However if prices rise too fast and it can get ahead od peoples earning power and impossible for them to afford goods and services creating the situation like hyperinflation wich kills the economy and destroys the value of local currency.
As currency traders, we need to be aware of any signs that inflation is getting off to high and you will very often see the central bank taking action to stop this occurring.
At the other end of the scale, we have something called deflation and this is where prices are in fact falling, you may think this is a good thing but in fact it can be deadly to the stable economy.
The reason for this goes back to what we just looked at, how good growing economy needs constant consumer spending to keep that growth rate up.
If all of the people think that the item they gonna buy will be cheaper next year then day may just save the money and wait for prices to come down , as a net effect on the economy this can have disastrous results and also something that central bank will do almost anything to stop.
So for major developed economy the sweet spot is generally to be around 2% per year inflation.
The banks will have the tolerance of around 1% before taking action.
The most powerful tool to tackle inflation is interest rates and a simple way of knowing what impact
inflation will have on interest rates is to remember the rule - to cut inflation you need to hike rates and to hike inflation you need to cut rates.
Aside from the main issue of inflation, central banks are also concerned about overall economic cycles because they play the part in a stable financial environment.
Economic cycles are inevitable and it is virtually impossible to sustain economic growth, sooner or later the cycle will change and economic conditions will change again.
This is precisely why there are cycles in first place.
So let's look at this cycles in more detail so we can get a good understanding.
Each cycle is made of 4 phases and they are expansion, peak, recession, trough.
In the expansion phase, the consumer spending is growing especially the purchase of big ticket products, although the interest rates are relatively low at he beginning of expansion they generally rise as the economy grows. Stocks perform well during expansion, including technology companies, durable goods manufacturers, and construction companies.
The currency tends to stop strengthening during this phase as the markets anticipate higher rates to come.
When the expansion is under way it eventually reaches a peak of productivity, at his point business in the economy are expanding however interest rates are climbing because investors and central banks are concerned about risks of rising inflation.
Rising interest rates make new homes less affordable for some consumer, as a result, the number of layoffs rises in the housing sector.
The stock markets anticipate economic peak so it's usually in decline by the time peak arrives.
The currency starts to top out as traders start to anticipate the start of next phase wich of corse will lead to interest rate cut.
We then enter into recession phase and early in this period's sale of the consumer product like cars, begin to fall leaving manufacturers to cut production, unemployment rises, income falls, interest is generally higher at he beginning of recession and fall through recession.
Most stocks perform poorly during the recession but companies like those that produce food,care products, farmaceut firms, financial companies often hold their value because these goods and services are that people need even more when times are tough.
Currency now starts to sell off as the market tries to predict how low the interest rates will be cut and speculators wait for banks next moves to combat a recession.
There are many different causes of recession but there are also few things hat will happen over and over again.
The first thing that can have the impact is rising interest rates conducted by the central bank if the economy gets too strong then inflation will get out of control so the bank needs to keep a closer eye on this and step in if it needs to.
They do this by raising interest rates and try to balance interest rates with economic growth so the economy doesn't grow too quickly and get out of hand.
The bank does not always get this right, for example, in 1982, the Federal Reserve in the US caused major recession because they had to hike interest rates quickly in order to bring down inflation that got over 13%.
Many economists say that they waited far too long to act wich resulted in recession.
Another common cause of recession is that business collect too much inventory this leads to very optimistic view at economy or simply because demand naturally drops.
When the build up occurs many manufactures cut production to bring it back in line, wich then lowers employment and income levels. This then spreads to other sectors and results in the slowdown.
Next we will look in Asset Bubbles.
Asset Bubble is when irrational demand drives up prices for certain assets the one that we would normally consider reasonable.
This happens when investors buy something just to because everyone else is buying it rather than carefully analyzing the benefits for themselves.
You may hear this be called the heard mentality.
In the past, many recessions have been caused by this asset bubbles forming and then selling off sharply when the markets realize what is happening.
This sellofs lead to drops in confidence. In the US massive selloff in the housing market was the reason for recession that started in 2008.
Oil price sharks can also be common sign to economic stability and growth this can occur in spiking prices cuts consumer spending power and increases business costs wich lead to recession.
We have decreased in exports as commom cause of recesion, this is expecialy for the nation that relies haevely on selling their products abroad because this has negative impact on the coutries income and growth.
For example: in 2008 major cause of recession in Germany was the drop in exports that occurred due to financial crisis spreading around the world.
Last phase is trough, during economic trough businesses have lowered prices for big ticket products the economy finds its footing as consumers spending starts to pick up, sells of new homes start to rise as buyers are lock in attractive prices
The stock market tries to anticipate the economic expansion and transportation stocks begin to rise.
And of corse currency traders now start to try to predict the expansion phase wich mean the interest rates will start going up.
This can be volatile for currency prices as the market tries to find the fair value based on upcoming expectations.
Understanding economic indicators will help you to identify this phases.
Trader Alen
Trader Alen
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