In the following lines, there is a dialogue between a beginner trader (B) and a successful trader (ST) which is aimed to describe the connection between forex trading and market cycles.
: What is meant by business cycle and how can it be used in forex trading?
ST: Business cycle is a model describing the growth and fall of economy. It can be used as a valuable tool to determine the economic trends and it is necessary for every trader to have a good knowledge and understanding about the business cycle. This model is one of the major drivers of economic events and trends across the globe and this is the reason it plays a very key role in shaping the currency prices and the trends they follow.
How can the business cycle determine forex trade trends?
ST: In most simple words, the key factor in driving the money supply growth is this cycle. And as the money supply is directly linked to the currency rates, forex trade trends also get influenced by any changes in the business cycle. However, this is just one side where the business cycle has impact. The business cycle’s nature defines several other things in nation like consumer demand, credit availability, unemployment and industrial production etc. And as a result, all these factors tend to have positive or negative impact on currency.
How does this happens?
ST: If a nation is in the cycle’s boom phase, international capital flows in that economy, through direct investment from foreign or international loans, searching for high returns on investment. This will result in capital inflows and currency will be appreciated. On the other hand, when a nation is in the cycle’s bust phase international capital will decrease and forex flows will cease and the currency will be depreciated. Following Newton’s 1st law, these conditions will continue until they get exhausted or government takes some action to stop these conditions.
How will this knowledge help a trader like me?
ST: You can avoid the currencies whose nations are in the bust period of the cycle and make the currencies whose nations are in the boom period your main focus. However, keep in mind that these nations will be net-creditors which means the external assets are higher than the liabilities and will have their currencies appreciated with their domestic economies making little difference.
How can a forex trader predict when these periods will start?
ST: Any economic sector can lead to start the boom or bust phase of the nation. If financial firms face problems they will try to solve their own problems by contracting credit. If a problem occurs in some other sector of the nation’s economy, it will result in contracting credit as the banking sector will predict bankruptcies and defaults. In both cases, the outcome is contracting credit and it can be observed by traders before the crises begin. You can keep track of this using Central bank figures, news reports, corporate sector loan rates and rumors about possible bankruptcies and defaults. In case of beginning of booming phase, the conditions will be vice versa with same process with expansion instead of contraction. Both boom and bust phases begin when one sector goes through major changes and that effects the other economic sectors subsequently and ultimately, the result is in form of boom or bust of the whole economy.
Does this means that when there is boom phase, stronger currencies should be send which do not fluctuate much to keep risks minimal for speculators and investors and in the bust phase, high deficit currencies should be sold?
ST: The boom and bust phases are linked all across the world but there is still no guarantee that all currencies will behave in the similar manner. Capital importers currencies and capital exporters’ currencies behave in totally different manner in both boom and bust phases of the business cycle. Traders can take advantage of profits divergence. For example, selling Euro and buying Turkish Lira when there is a boom phase and doing vice versa in bust phase will be profitable for traders.