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The markets are a forward-looking mechanism that trades differently depending on the economic cycle. The economic cycle goes through several changes, and the markets usually adjust. Riskier assets generally outperform when a central bank reduces interest rates. The reverse is typically true when a central bank is raising interest rates. When economic growth is expanding rapidly and inflation rises beyond a target set by the monetary policy authorities, a central bank will usually begin to raise interest rates to slow inflation.
When growth or employment begins to fall, as inflation is declining, a central bank will usually decrease interest rates which will buoy riskier assets. Each asset class will rise or fall based on whether a central bank is accommodative, neutral, or restrictive. Generally, riskier assets begin to increase after a trough in a cycle. During an expansion, commodity prices will increase as demand accelerates for raw materials. Understanding the markets and economic cycles will allow you to alter your portfolio and create a diversified portfolio. Here is how the markets react during upturns and downturns.
Not all asset classes are the same, and the performance will change based on the timing of the economic cycle. There are several stages of economic cycles. Expansion is a stage where the economy experiences accelerating growth as interest rates tend to be low. Banks will lend to consumers at lower interest rates and production increases as liquidity rise. As more money circulates throughout the economy, employment, wages, and corporate profits start to rise. The flow of money buoys output, and the acceleration of inflation starts to take hold. During an economic expansion, there will be trends in forex trading, stock markets, and bond markets. Accelerating growth and inflation expectations usually lead a central bank to raise borrowing rates to slow inflation.
As the expansion accelerates, it eventually peaks in a cycle as growth hits its maximum rate. At an economic apex, wages are usually accelerating to keep up with the demand for labor. Peak growth usually corresponds with elevated levels of inflation as prices rise. Businesses are traditionally investing in keeping up with accelerating levels of development. As wages rise to unsustainable rates, central banks will accelerate their restrictive policies to reduce accelerating inflation. As interest rates rise, borrowing becomes more complex, and businesses reevaluate their budgets and growth prospects.
The acceleration in rising interest rates cuts off borrowing and liquidity. As borrowing from banks becomes more complex, businesses and consumers slow their borrowing needs. The reduction in activity begins to lead to a contraction. The output starts to slow, and business stop hiring and potentially begin laying off workers. Central banks will move from a restrictive to a neutral policy at some point in the downturn. As the news spreads that companies are laying off workers, spending declines, and consumers pull back their spending habits. If the contraction accelerates, it can become a recession with negative growth. If the spiral continues, it can become a depression. As growth and employment decline, inflation will also drop, which could lead a central bank to change from a neutral stance to an accommodative policy.
The Bottom of the Cycle
The bottom of the economic cycle is when the economy hits a low point. By this point, a central bank has started to reduce interest rates. The accommodative stance helps to buoy borrowing as corporations and consumers begin to borrow. The low point in the cycle usually represents a painful time for consumers and corporations. There is typically a negative impact from the lack of spending and growth. As interest rates decline to help buoy growth, an expansion should take hold leading to the beginning of the economic cycle.
Economic cycles usually do not change on their own. Interest rates play a role in how economies expand and contract. Central banks are generally tasked with controlling inflation and maximizing employment and growth. During an expansion, there will be a point where a central bank will move from a neutral policy to a restrictive policy which should cause a peak in growth. During a downturn, a central bank typically changes from a neutral approach to an accommodative policy to fend off a recession.
Central banks usually control short-term borrowing rates, although they can also be active in the secondary markets. Borrowing rates, such as the repo or Fed Fund rates, are rates that banks lend to one another. As the short-term borrowing rate rises, the rates at which banks lend to consumers will increase. As short-term borrowing rates decline, a bank's lending rate to its customers will also decrease.
When activity at the short end of the interest rate curve is insufficient to buoy economic growth, a central bank might consider purchasing long-term government bonds to reduce long-term lending rates. This scenario occurred during the great financial crisis and the Covid crisis, as central banks from around the globe started quantitative easing. By purchasing government bonds, the central bank artificially pushes down interest rates as rates move in the opposite direction to the price of a bond. The lower yields on long-term bonds will reduce mortgage and corporate rates helping to increase liquidity and enhance economic growth. The reverse of quantitative easing is quantitative tightening. In this situation, a central bank that has purchased government bonds and increased the size of its balance sheet will need to sell off the bonds. As they sell these bonds, the bond rate rises, making borrowing less attractive.
The different economic cycles and the change in interest rates make different assets attractive at various times. When interest rates decline after a trough in economic activity, riskier assets that have been beaten down become attractive. Cyclical stocks, such as technology shares like Apple and Microsoft, will start to rally, helping to buoy the broader markets. Market participants begin to look out into the future and see lower rates. Lower rates increase the discounted cash flows of companies, which makes their value more attractive. As rates continue to decline, a rally in riskier assets will commence. Bond prices will also benefit as rates start to fall. Since interest rates move opposite to bond prices, the rate drop will help buoy bond prices. Real estate will also benefit from lower mortgage rates, making purchasing a home or investment property more attractive.
The forex markets are somewhat different as they are a pair of currencies. When a country lowers its rates faster than others, its currency will usually decline. While there is some benefit from rising riskier assets in that currency, the yield differential between the country that is lower rates quickly moves in favor of its counterpart. The yield difference is between one country's borrowing rate and another country's borrowing rate. The changes to the differential will impact the forward rate, which could drive the trend in the forex market.
The reserve is also valid. When one country increases its borrowing rate faster than others, its currency exchange rate will usually rise. For example, the Federal Reserve raised rates more quickly than its trading partners in 2022, which helped buoy the dollar relative to other currencies.
Commodity prices usually benefit when economic growth is accelerating. Commodity prices are driven by supply and demand, and when growth starts to accelerate, the need for raw materials will rise, pushing up the cost of commodities. During a contraction, the commodity demand usually falls, putting downward pressure on prices.
Understanding economic cycles and how assets perform during each period is essential. Economic cycles include an expansion that leads to a peak in growth and inflation. This cycle period is followed by a downturn and potentially a recession, leading to a bottom in economic activity. Economic cycles are usually driven by changes in interest rate policies that central banks control. Most central banks have mandates to control inflation expectations. Some central banks are also mandated to maximize employment. When central banks raise rates to reduce inflation, their activities generally lead to a downturn. When a central bank lowers interest rates to spur growth, its measures usually lead to an expansion.
Assets such as stocks and bonds usually outperform when a central bank is lower interest rates are lower. Riskier assets can exceed even when a central bank moves to a neutral policy. Once a central bank starts to move to a restrictive policy, riskier assets may decline in value. Defensive stocks and assets will outperform as a central bank raises rates. The relative change in interest rates impacts the exchange rates of currencies.
The materials contained on this document should not in any way be construed, either explicitly or implicitly, directly or indirectly, as investment advice, recommendation or suggestion of an investment strategy with respect to a financial instrument, in any manner whatsoever. Any indication of past performance or simulated past performance included in this document is not a reliable indicator of future results. For the full disclaimer click here.
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