The credit and asset price cycle - The potential for bubbles

 

From Between Debt and the Devil: Money, Credit and Fixing Global Finance by Adrian Turner 

This credit and asset price cycle map provides an effective description of the feedback loop which creates a cycle. Start at any point in the cycle and you can walk through how credit gets extended and leads to higher prices. you will get the opposite if there is a fall in prices. Of course, one of the key components of the credit cycle is the link between rising prices and higher expectations for future asset prices. Once you have momentum as a driver of expectations you are ready to have a positive feedback loop and potential for a bubble. You need a negative catalyst to shock asset prices and force expectations lower.

Momentum, which leads to higher prices, allows for more lending against the higher collateral values. The lending will lead to more borrowing which of course forces prices even higher. This is why change point detection is so critical. An investor needs to develop tools to measure or assess when the reversal will begin. The reversal of the credit cycle is not likely to be immediate once there is a fall in prices, but investors need to realize that once credit is pulled from asset markets the price declines will increase.

Trends in all assets can be closely aligned with the credit cycle. Unfortunately, it is often hard to match credit extension with specific markets, so it is hard to see the flow-through in the cycle.