What Is An Economic Recession
An economic recession is characterized by a large downturn or contraction of an economy for a prolonged period of time. A recession is usually seen as negative GDP growth for two consecutive quarters or more. As a trader it can be helpful to understand when we are in a recession because it may affect how you approach the market, especially if you’re a swing trader, and it may even help you with making investment decisions for any long-term positions you have in the markets.
What Causes Economic Recessions?
Overspending & Overborrowing
Overspending and borrowing too much money are the biggest causes of recessions. When people and businesses take out loans and spend more than they can afford, it creates a bubble that eventually bursts. When this happens, people lose their jobs, which in turn makes them default on their loans. This puts a strain on banks who have to write down these bad loans due to the decrease in demand for loans. The banks then start cutting back on lending, which causes businesses to lose money, which leads to job cuts. This cycle continues until the economy returns to normal levels of spending and borrowing.
Excessive Government Spending
Excessive government spending which is usually paired with quantitative easing or more simply put, central banks printing too much money can trigger recessions later on down the line as side effects of overspending and printing money can create inflation, or in some rare cases hyperinflation like we’ve seen in countries like Venezuela, where the value of a country’s currency becomes nearly worthless.
This is why over COVID-19 we saw the Federal Reserve print money at unprecedented rates, and the U.S. national spike in Q1 2020. Global debt increased by a staggering $19.5 Trillion from 2020-2021 during COVID-19 (source).
This leads us to our next cause of economic recessions, inflation.
Inflation
Inflation is caused by things like central banks printing too much money, and the national debt growing as the government continues to borrow and spend large amounts of money.
When a country’s central bank prints more money than it needs, it causes inflation because there are more dollars in circulation. The price of goods goes up as a result of this increased money supply, which means that people have less money to spend on their everyday needs—and that means they have to pay more for those needs.
The national debt is also an important factor in determining whether or not inflation will occur in a country. When the national debt is high, it means that there is more money owed than can be repaid by the government. This causes inflation because people will lose confidence in their currency and begin hoarding cash instead—which increases demand for dollars while decreasing supply.
Asset Bubbles
Asset bubbles can cause a recession by causing the prices of assets like stocks, bonds, and real estate to rise beyond their intrinsic value.
When the price of an asset is driven up by a bubble, it creates a vast discrepancy between how much money people are willing to pay for an asset versus how much it’s actually worth. This causes problems because it means that many people who have invested in those assets will actually lose money on them when they turn out to be overpriced. Since many people rely on these investments as their primary source of income, they’ll stop buying things and spending money on things like food and housing when they don’t feel confident about their investments’ safety. This lack of consumer demand leads to businesses closing their doors and putting people out of work, which further exacerbates the problem.
Geopolitical Conflict & War
It’s no secret that military conflict, war, and economic sanctions can be a contributing factor to recessions too.
The war in Ukraine is a great example of this in recent times. The war has been going on for almost five years, and the conflict has been a major factor in causing a recession, especially when you consider the previous points mentioned in this article.
One of the ways the recession is being made worse is by increasing prices of natural resources like oil and natural gas. The reason for this is twofold: because of sanctions placed on Russia by the West, their supply of natural gas has decreased, causing a hike in prices; and because these sanctions have made it difficult for Russia to access global markets with its own products (like oil), they’re having to sell them at higher costs due to lack of demand.
This means that any businesses that rely on these resources will experience an increase in operating costs—and since most companies pass these costs down to consumers through price hikes, this means that most people are paying more money for their energy needs than they would have otherwise, meaning they have less money to spend on goods and services which help to keep the economy thriving.
How Does All of This Affect Your Trading?
Well, that’s a great question. For some of you, it won’t affect how you trade the markets, especially if you’re a day trader. If you trade indices or stocks, you’ll likely see these “risk-on” assets drop as we move into a recession largely due to the fact that investors don’t want to park their capital in an asset that is falling, which creates further selling pressure, and because companies will shrink and lose money, which fundamentally is another cause for the price of stocks to fall in price.
In the forex market however, you may see things like safe-haven or “risk-off” assets like the U.S. dollar and precious metals like Gold get stronger as investors rush to sell assets and investments for those currencies.
Recessions really affect swing and position traders most, but if you’re trading intraday, you’re likely insulated from all of this since you trade long and short and get in and out of positions within a day most of the time anyway.
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Robert Castillo
@coldwaterfx
FX Trader & Analyst
Writer & Editor
Rob is a funded trader from Toronto, Canada, and has been trading currencies, commodities, stocks, and cryptocurrencies for over 7 years. Outside of trading he enjoys making music, boxing, and riding his motorcycle.
