Debt Cycles part 1. Introduction and Short term cycle

 Debt is, at its simplest, a promise to repay a sum of money borrowed later. It may involve interest and other debt service charges. Payment of interest usually means an extra portion of the amount borrowed that is payable over a period of time. The creditor wants the interest rate to be higher than the cost of borrowing and the rate of inflation. It wants the value of the money to be depreciated in excess of the total amount of money repaid and interest over the loan period. In other words, real returns must be positive. A sensible debtor wants a used debt to bring a positive real return. Sometimes it makes sense to take on debt with a negative real return to avoid complete economic collapse. In other words, the debtor buys time to get his finances in order.

The debtor becomes insolvent if he is unable to pay the debt. To do this, he has to provide collateral. The creditor must make a probability assessment of how well the debtor can pay his money back, either directly from the debtor or by redeeming the collateral. The more uncertain the repayment and the lower the security, the higher the interest the debtor will have to pay. This happens when the creditor understands the situation of the debtor. At the peak of debt cycles, creditors’ lack of understanding of debtors’ ability to repay is at its greatest.

The best understanding of the role of debt in the economy is obtained by looking at remittances in the big picture of the economy. In the following equation, the sources of money are on the left and the uses are on the right:

Money + Liabilities + Income = Consumption + Assets + Savings

The equation is bidirectional. For example, consumption is the income of the counterparty. Some of the increased money supply from the left side can be consumed, some can be used to buy assets or put into savings. When the central bank tightens its monetary policy and interest rates rise, debt is often reduced. This reduces consumption and / or the purchase of assets which reduces revenue. The opposite phenomenon occurs when the interest rate decreases. It will increase the amount of debt which is likely to increase consumption which will increase revenue. Both are self-reinforcing series of events. By looking at the varying amounts of the parts of the equation, you can see how the debt cycles are progressing.

Short debt cycle

Short debt cycles normally last 3-8 years. The length depends on the previous cycle and some other factors like changes in central banks´ interest rate policies. The further it progresses and / or or the deeper the economy goes down the longer the next one will last. What I mean is how much excesses people, companies and central banks have made. The worse the over-indebtedness, the longer the damage will be repaired. The short debt cycle is also called the general economic cycle. As I mentioned earlier, central banks regulate short debt cycles mostly by either tightening or loosening monetary policy. This is mostly done by raising or lowering interest rates. Exceptions arise mainly from the bursting of a debt bubble at the end of the long debt cycle.

Short debt cycles can be divided into four parts: growth, peak, decline and recession. Growth starts at the beginning. Interest rates are low and borrowing is easier. Demand for interest-sensitive products such as housing and cars is growing first. Growth is initially rapid. Unemployment is falling and the average working week is lengthening through rising demand and output growth. Inflation remains low despite debt increases and economic growth. The best investment targets can be found in equities. The situation for commodities and inflation-hedges is deteriorating. Later, economic growth will slow temporarily. Inflation will remain low, interest rates will fall and stock prices will calm down. The decline in the prices of commodities and inflation-protecting assets is slowing down.

At the end of the growth, the pace accelerates. Wages are rising faster and production capacity is coming back. Inflation is accelerating, consumption is peaking and interest rates are rising. Equities make their last rise in the cycle before falling, and inflation-hedged investments perform best. The peak is coming because the economy has overheated. The latter will lead to tightening of the central bank's monetary policy. Liquidity is declining and interest rates are rising. Economic growth is starting to decline. The amount of money is shrinking and the growth rate of debt is declining. The stock market will start to decline before economic growth goes into the red. Eventually the recession will hit.

Economies are in recession on average 10-12% of the time. During them, economic growth will average -3%. At the beginning of the recession, the economy is shrinking. At the same time, the prices of shares and inflation-hedged investments are falling. The central bank is not loosening its monetary policy and inflation is falling. In the end, the central bank fears recession and deflation, so it loosens its monetary policy. Interest rates fall and stocks rise. Commodity prices are low, as are inflation-hedged investments. With low interest rates and rising stock prices, we are moving from a recession to the beginning of a new cycle.

The operation of short cycles depends much more on external factors such as major natural disasters like pandemics and wars. The latter are wars between great powers and neighboring states. Less often, export bans like OPEC`s regulation of oil production have effects on cycles. Utilizing short debt cycles in investing requires skill which most of us do not have. I cannot recommend anyone to take advantage of them. It is easier to understand longer cycles.

One of the best signs of a recession is the shift of the yield curve to negative. It refers to a situation where the interest rates on longer government bonds are lower than those on their short-term bonds. This usually occurs about 12 to 18 months before the recession. The exact timing of interest rates does not tell the future recession. This indicator is not easy for an investor to take advantage of. It may be used as a signal to increase cash position for future investments. It can be seen as an indication that the leverage should not be increased. Stock prices can also predict a future recession 6-12 months before that, but they are a more uncertain indicator. They can be used more to invest in other asset classes.

Recessions are poorly predicted. This is true for both amateurs and professionals. The latter manages to predict a recession when it is underway. According to an IMF research paper, between 1992 and 2014, economists out of 153 recessions in 63 different countries managed to predict only 5 in April of the previous year. Instead, in October of the recession, economists correctly predicted 118 times out of 153 recessions. It can be said that economists ’predictions of a recession are not worth reading or listening to.