Market cycles and currency trading

In this article we will discuss the relationship between market cycles and forex through a dialogue between a beginner and a successful trader. The successful trader is ST, while the beginner is B:
B: What is the business cycle and how can I use it trade forex?
ST: Business cycle is the name given to the growth and contraction phases of economic life. It is one of the most important determinants of economic trends; no trader can be called a trader without understanding the inevitable nature of cycles. Since it is one of the major drivers of all trends and economic events on global scale, it plays a very important role in determining currency prices and their trends.
B: How does the cycle determine forex trends?
ST: On the most basic level, the cycle is the most important driver of money supply growth. Since money supply is closely related to currency values (the more there is of a currency, the less its value will be) forex trends also respond to cyclical developments. But this is just a tiny portion of the power of the business cycle. The nature of the cycle also defines such variables as unemployment, consumer demand, industrial production, availability of credit, and these variables in turn lead international capital to shun or favor a currency.
B: And how does that happen?
ST: When a nation is going through the boom phase of the cycle, international capital will flow there in search of better returns on investment, through channels like foreign direct investment, or international loans. Those will create inflows of capital, and cause the nation’s currency to appreciate. Conversely, when a nation is going through the bust phase of the cycle, international capital will shun it, dry up forex flows, and cause the currency to depreciate. As with Newton’s First Law, these developments will keep going on until they’re exhausted through market developments, or are contradicted by government action.
B: How can I benefit from this knowledge?
ST: You can short the currencies of nations that are going through the bust period, and long the currencies of those that are just entering the boom period, with the caveat that those nations that are net-creditors (external assets are more than liabilities) will see their currencies appreciate, regardless of the their domestic economies.
B: Is there a way to anticipate the beginning of these periods?
ST: The boom and bust phase of the cycle can be initiated by any sector of the economy. When the problems begin among financial sector firms, these will contract credit to overcome their own problems. When the troubles arise in another sector of the economy, the banking sector will contract credit in anticipation of defaults and bankruptcies. In either case, the result is contracting credit, and this can be observed, usually before the crisis begins, in Central Bank statistics, corporate loan rates, and news reports that speak about layoffs and bankruptcies. Of course if the phase is a boom, the developments will be in the opposite direction, with expansion replacing contraction, but the process is similar. The boom and bust both develop through contagion; as the dynamism, or rot in one sector spreads to others, general economic activity is buoyed or suppressed, and the boom or bust is underway.
B: All that theory is good, but where do I actually look to see the beginning or end of these phases?
ST: There are two types of indicators for that purpose, lagging, and leading. Unemployment numbers, central bank policy actions, bankruptcies are all lagging indicators for a bust, and cannot be used to predict anything. The best leading indicator is supplied by careful analysis of the economy and identification of the areas where the greatest imbalances accumulate. I know that this will be difficult for you, so you’re invited to seek your leading indicators in the loan surverys of the central banks, as we had discussed before, and delinquency statistics. These are not exactly leading indicators (since they also respond to some already existing malaise in the economy) but they are close to being such, because banks are one of the earliest actors in any economy in feeling the pain of impending recessions. They are the first to hear of loan delinquencies, and loan delinquencies lead to credit contraction, which leads to contagion, as we discussed, and a deepening crisis.
Another important indicator for anticipating a recession is the status of inventories. GDP growth that is mostly created through inventory accumulation is one of the safest signs of an impending recession. Firms have to liquidate inventories, and if they find out that they cannot do so through patience, they will simply begin to reduce capacity and eventually eliminate jobs.
For predicting the boom phase, most of the above data can be useful, but for a healthy and long lasting boom all of them must eventually be pointing in the same direction. For instance, first the central bank rates must come down, then unemployment growth must level off, industrial production must begin to strengthen, and so forth. Usually, central bank rate reductions, followed by easier credit conditions, are some of the more reliable indicators for predicting a boom, but a financial crisis may make these indicators irrelevant. In such a case, the trader must focus on the real economy, and unemployment, to get an idea on the stage of the economical development.
B: So you say that I keep my eyes on the financial sector always, and on inventory statistics for detecting a bust, and for a boom I wait for a number of areas of the economy to find vigor and strength.
ST: Yes. This is not the best way of anticipating the circles, but at least you will never be in denial when a recession strikes.
B: How does globalization impact the nature of cycles, and what is the implications of this for currency trading?
ST: Globalization causes the booms and busts to be synchronized across economies which results in the phases of the cycle both being stronger and deeper than it was in the past. Before the end of the cold war, for example, a large part of the world would be relatively immune to the effects of speculative bubbles in the western world due the nature of socialist economies. Before that era, regional and national economic activity was always somewhat isolated from the world at large as national authorities sought to maintain a degree of economic independence. As globalization brought all these phenomena to an end, we now have global booms and busts. What this means for the forex market is that while volatility dissipates to extremely low levels during the boom phase, it rapidly skyrockets during the bust, and makes leverage an even more sharper sword than it usually is. So in that sense, in a globalized economy the currency trader can increase leverage during the boom phase, while lowering it significantly during the bust.
B: So if booms and busts are correlated on a global scale, how can I find abnormalities in the market to exploit?
ST: This is not difficult, because the cycle is driven through the accumulation of imbalances at the micro-level, such as that between a bank and a mortgage borrower, right up to those at the macro-level where some nations run forex surpluses, while others suffer from deficits. Thus, at the end of a bust phase nations with sound and conservative economic policies will have absorbed too much capital, which then flows to risky assets in the boom phase. Conversely, towards the end of a boom phase, too much risk taking will have caused nations with weaker fundamentals to possess either a swollen real sector, or an artificially expensive currency, which are then normalized in the bust. The cycle readjusts these imbalances, and the trade opportunity lies in the exploitation of this correction.
B: You mean that during the bust you sell the currencies with high deficits and non-conservative policies, and during the boom you sell the sounder ones which cannot create enough activity to satisfy the risk appetite of investors and speculators.
ST: Booms and busts are correlated across the globe, but that doesn’t mean that all currencies behave in the same way. Currencies of capital importers behave in the opposite direction to those of capital exporters during both the boom and the bust phases of the cycle. The trader can exploit this divergence for profits, for example by selling the Euro (current account balance, prudent fiscal policies), and buying the Turkish Lira (real estate bubble, external dependency, large deficits )during a boom, and doing the opposite during the bust.
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