Every economy has a cyclical trend. There are phases of contraction and phases of expansion of the economic cycle.
Generally, these economic cycles draw minimums and maximums on the graphs of the various asset classes.
Cyclical Trend: Economy Contraction
When the economy shrinks, central banks implement an expansive monetary policy and therefore, a reduction in interest rates.
The reduction in interest rates causes an increase in bond prices. This is because the new bonds have a lower yield than the old ones and therefore a higher cost.
Investors try to buy bonds at the highest rate and are willing to pay them more. The market expectation must also be considered. More traders expect future rate cuts and more the price of bonds rises.
Many times the simple news of the lowering of rates to move entire markets is enough.
During a recession, the real economy is at its lowest point. Meanwhile, the stock market may have already started to rise again. Stock market valuations are also based on expectations. If traders believe that low rates will help the real economy, the share price starts to increase.
Cyclical Trend: Expansion
The real economy is slower than financial markets, and therefore, the expansion phase will come sometime later. In the meantime, the shares could be at their highest. Likewise, even commodities will have increased their quotations.
When the real economy is in its peak of expansion, central banks will have to start raising interest rates.
In fact, during the expansion phase, consumer prices will tend to rise also due to the rise in commodity prices.
The central bank has the main objective of controlling inflation. The tool to control inflation is interest rates.
The economy will react slowly to rising interest rates. The stock and bond markets could respond violently. In recent years we are witnessing a dizzying fall in interest rates. Whenever banks try to raise rates, the markets react exaggeratedly. It almost seems that we can never return to normal.
So the stock and bond market will once again anticipate the real economy. Commodities will take longer to turn down.
When even the real economy starts to deteriorate, it will enter the phase of contraction of the economic cycle. In the meantime, the shares and bonds will already be at a minimum. The central bank will start lowering rates, and everything will start all over again.
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Resources: Wikipedia
