All Financial Wisdom

Why are there economic cycles?

By  | 

In the wake of the US Federal Reserve’s expected change in interest rate policy, we would like to explain, in macroeconomic terms, the cyclical nature of economies.

If you analyze the economy over the long term, using GDP (gross domestic product) as a variable, you’ll note that it doesn’t evolve in a linear and progressive way over time, but rather, its movement occurs through waves that are determined by economic cycles.

It’s no coincidence that the production of goods and services in a country does not evolve steadily since they influence huge variables linked to production. Among all these variables, the most notable is the role of money and, especially, interest rates, which allow for the financing of investment projects and consumption needs.

Let’s review the four phases of the economic cycle: Boom, Stagnation, Recession and Recovery.

Recession phase

In technical terms,  a recession occurs when there is a fall in gross domestic product for two consecutive quarters. In the recession phase, liquidity problems are notorious and solvency problems arise that give rise to bankruptcies of companies.

Companies with very impaired balance sheets see their economic activity contracting and can not cope with their obligations, and their  assets are beginning to deteriorate due to lower revenues. Faced with lower sales, one of the variable costs is labor, which is why layoffs typically occur, and the level of unemployment begins to increase.

In the full development of the recession, solvency problems turn into bankruptcies or the company is forced to restructure its business model and staff. Companies settle their assets over a longer period of time and with a lower marginal return to reduce their level of leverage.

All these liquidations have a deflationary impact and, for that reason, the high interest rates are meaningless and the Federal Reserve seeks to reduce interest rates accordingly.

Recovery phase

In the recovery phase, the restructuring processes of companies has mostly been carried out, reducing levels of leverage, so that the business fabric is healthy, which allows us to look for new business opportunities.

At the beginning of the recovery phase unemployment levels reach maximum highs, but as new businesses slowly develop, unemployment levels manage to change inertia and decline, leading to an improvement in consumption levels.

In the recovery phase, the central bank maintains interest rates very low since there is no inflationary pressure and with the final objective that, once again, the demand for credit is generated to finance new investments: The boom stage.

To generate this incentive, the Fed tends to introduce negative real interest rates, meaning that companies can actually borrow money for next to nothing in order to invest (and grow, and hire).

The role of the central bank and the bond yield curve

As we have seen, it is impossible to understand the evolution of the economic cycle without the active role that the Central Bank plays since they determine the level of interest rates.

Given the monetary manipulation exercised by central banks, we can see, thanks to the leading indicators, how the economic cycle is. For this, the best indicator is the yield curve of the sovereign bond in the different periods.

We think that in a normal scenario, short-term interest rates will be lower than long-term interest rates. In other words, the 1-year bond yield should be less than the 10-year bond yield, showing a yield curve with a positive slope.

This base scenario is coherent because, by compromising the money over a longer term, investors demand greater profitability due to the greater degree of uncertainty and the eventual escalation of inflation that impacts the real return on investments.

In this context, there are incentives to capture money in the short term, and invest it in the long term, generating this expansion of the economy. As stocks have recently rallied during Trump’s new presidency, due to favorable proposed looser regulation and corporate tax policy, the Fed is likely to raise interest rates, paving the way for job growth a new wave of investment by companies.

 

Leave a Reply

Your email address will not be published. Required fields are marked *