Market Dynamics and Synchronous Business Cycles

A key driver of the current dollar decline is the expectations that the US with see a further slowdown while the rest of the world, especially Europe will continue to grow. Stronger growth in the rest of the world may lead to monetary policy outside the United States that drives rates higher. On the other hand, the expectation for the Fed is that the next move will be to lower rates. An underlying assumption for this story is that the old adage that if the “United States sneezes, the rest of the world catches cold” does not occur. Clearly, if business cycles are synchronized this time, the growth differentials will stay consistent, monetary policy will be similar, interest rate differentials will not change significantly, and investment opportunities will not differ. The issue of synchronous business cycles is a driver of current financial flows.

Is this time different? An answer to this question requires a historical review of the business cycle relationships around the world. The history of whether business cycles were synchronous is not as clear-cut as noted in the cold analogy. First, there have not been many recession in the last 35 years. Second, the mix of trade and financial flows has changed significantly since the last major recession in 1990 and the downturn in 2001. Past history shows that all slowdowns in the US that have not always carried over to the rest of the world. See Chapter 4 of the IMF Economic Outlook, “Decoupling the Train? Spillovers and Cycles in the Global Economy”. http://www.imf.org/external/pubs/ft/weo/2007/01/pdf/c4.pdf

What is needed to have commonality across economies is a global causal factor for the slowdown. We have seen that with oil shocks in the 1970’s and the stock market decline of 2001. This common link may not be the case currently where the US slowdown is being driven by the housing market. Global integration is another key determinant for the cycle spillovers to occur. If economies are more integrated with trade or financial flows there is more likelihood for synchronous cycles. While the US is still the market leader in trade, global trade flows are more disperse than in the past. While economies are more integrated than in the past, the US may not have the same power to drive business cycles. The exception may be with regions such the Western Hemisphere which has become more integrated. Nevertheless, financial flows have become more important as a transmission mechanism. However, in this case, the housing market problems have yet to carry over to the stock or bond markets. The US specific causes of the slowdown may mean that there will be a decoupling of business cycles.

The differences in economic growth will manifest in changing asset prices. Further dollar declines. Changes in relative interest rates. Increased equity opportunities internationally.