The economic cycleThe slow wheel that turns every market.
The economy grows, peaks, shrinks and recovers in cycles that last years. Knowing the phase, and whether the central bank is adding money or holding it back, explains a large part of what markets do.
A wheel that speeds up and slows down
Picture a slow water wheel. A gate controls how much water drives it. For a few years the wheel turns faster and faster. Then the water level drops, the wheel slows and for a short while it almost stops, until suddenly more water pours in and it speeds up again. Half a turn of this wheel takes several years.
The economy moves the same way. In the growth phase it expands until it reaches its peak. It stays near that size for a while, then starts to shrink, sometimes slowly and sometimes fast. A sharp contraction is a recession. Eventually the economy hits a low point, a new upswing begins and the cycle starts again.
The phases always come in the same order, and the cycle repeats at fairly regular intervals. If you know where the economy stands today, you have a fair idea of what is likely to come next. Traders who simply extrapolate today’s growth tend to buy near the peak, just as the central bank starts to close the gate.
GDP rises, the wheel speeds up
Full speed, low unemployment
GDP shrinks. A sharp fall is a recession
A new upswing starts
GDP keeps the score
The size of an economy is measured by its gross domestic product, or GDP: the total value of all the goods and services a country produces. When GDP grows, the economy is expanding. When it shrinks, the economy is contracting.
Each phase also leaves other traces, in unemployment, wages and inflation. The table shows the main ones, and they are exactly what central banks watch.
GDP has one drawback: it is published once a quarter and describes a period that is already over. That is why later lessons add faster signals, above all the monthly ISM PMI survey and what bond yields say.
| Phase | What you see | Central bank |
|---|---|---|
| Growth | GDP rising, more jobs, more spending | Lets it run |
| Peak | Low jobless rate, high wages, inflation above 2% | Closes the gate: hikes |
| Contraction | GDP falling, jobs lost | Opens the gate: cuts, adds money |
| Low point | Activity bottoms out, inflation low | Keeps the gate open |
The central bank is the gate
In the water wheel picture, the gate is the central bank. It regulates the money supply, the amount of money that flows through the economy. Its main tool is the key interest rate, and when that is not enough, it can create money to buy bonds.
When a recession is coming or has already arrived, the central bank opens the gate. It cuts rates and pumps more money in, so that people and companies borrow, spend and invest again. When the economy runs at full capacity, with low unemployment and strong growth, it closes the gate a little so the economy does not overheat.
The gate cannot stop the wheel, only speed it up or slow it down. Its decisions follow the phase, so phase and gate always belong together in your analysis. What opening or closing the gate does to stocks, currencies, bonds and gold is the topic of the lessons on the key interest rate and on quantitative easing.
Why traders start here
Stocks, currencies, commodities and bonds all react differently when the money supply changes. A trader who knows the phase and the direction of the gate already knows which way the strongest currents in the market are likely to flow, before looking at a single chart.
The biggest shifts come at the turns: the first rate cut after a long run of hikes, or the first hint of hikes after years of cheap money. If you see early what a central bank is going to do, you can catch the trend that follows near its start.
The rest of this module adds the pieces one by one, from inflation and interest rates to bonds, the dollar and commodities, and the last lesson puts them together.
Before you look at any single market, ask 2 questions: where are we in the cycle, and is the central bank opening the gate or closing it?
What to watch for
A run of weaker growth numbers while the central bank still sounds firm is often the first sign that the gate will open. Listen for a softer tone at the next meeting, because the currency tends to react to the shift before the first cut.
Economies are rarely in the same phase at the same time. If one central bank is closing its gate while another is opening its own, the currency pair between them tends to trend.
In short
- The economy moves in a cycle of growth, peak, contraction and low point, and each phase lasts years rather than weeks.
- GDP measures the size of the economy, and the central bank acts as the gate: it adds money in a downturn and holds it back when the economy runs at full speed.
- Before you look at any market, ask where we are in the cycle and whether the central bank is opening or closing the gate.
Questions
How long does one cycle last?
There is no fixed length. Half a turn of the wheel takes several years, and in the US the ISM PMI, covered later in this module, has dropped into recession territory roughly every 8 to 10 years.
What counts as a recession?
A sharp contraction, when the economy actually shrinks instead of just growing more slowly. A common rule of thumb is 2 quarters of falling GDP in a row.
Key terms
- Economic cycle
- The repeating pattern of growth, peak, contraction and recovery that every economy goes through.
- GDP
- Gross domestic product: the total value of everything an economy produces. The broadest measure of growth.
- Recession
- A period in which the economy shrinks instead of growing, usually with rising unemployment.
- Central bank
- The institution that sets a country’s key interest rate and controls the money supply, like the Fed, the ECB or the Bank of England.
- Money supply
- The total amount of money in an economy. More money chasing the same goods tends to push prices up.