What Causes Recessions and How to Stay Safe

Investment community rumors about an upcoming recession. What will cause it? And How to pretect our day trading?  In recent months, the talk in the investment community has been about the upcoming recession. Reports from various investment banks point to one happening in 2020.

This has been ‘confirmed’ by the recent inversion of the yield curve . When this inversion happens, the yields on the short-term bonds rise above those of the long-term government bonds.

Another point to consider is the CBOE index (or VIX). The VIX was created to measure the amount of fear that traders have in the market by observing the pricing of the options market. Even without the VIX, the volatility is evident with the large swings happening in the market.

All this has led many investors to start talking about a correction or even a recession. All this are important things for investors because it would wipe out their gains. For traders like you however, there would be no major implications because your goal is to bet on the direction of the market

This article explains what causes recessions  and how to be protected.

Some of the best-known recessions

A common misconception among many market watchers is that recessions happen as a result of the general economic growth. They opine that asset prices like stocks, bonds, and real estate rises when the economy is expanding and decline when the economy is weakening. This thinking is usually flawed, if you consider what has caused the previous recessions.

In the 1990s, the Federal Reserve left interest rates so low to deal with the Asian currency crisis. This was a period in which a crisis in the East and Southeast. The crisis started in Thailand, with the collapse of the Thai Baht as a result of lack of a foreign currency.

As this happened, other Asian currencies like those of Japan, Indonesia, and South Korea were the most affected. They were followed by Hong Kong, Philippines, and Malaysia.

To prevent the contagion, the Federal Reserve lowered interest rates. As this happened, investors appetite for risk increased in the US and most of them started to invest in risky assets like new technology companies. Ultimately, this ended in early 2000 when the dot com bubble burst. The dot com bubble led to a global recession as asset prices declined.

After the dot com bubble, the Federal Reserve lowered interest rates sharply. The bank always does this with the goal of attracting more capital to the financial market. As a result of the lose monetary policy, banks started selling credit in large scale. This happened because of the new products, which included the credit default swaps, CDOs, and MBs.

As the Fed started raising interest rates, the delinquencies in the housing sector started piling up. Ultimately, the bubble burst in 2008.

You can learn more about recessions in CNBC and History Channel.

What causes recessions? A common Misconception

Yield Curve

The most common predictor of when a recession will happen is the yield curve. This is the difference between the longer-term treasury bonds and the short-term ones. In a normal market, the yields of the short-term bonds are usually lower than those of the longer term.

This is because of the premium investors ask for when investing in longer-term bonds. Therefore, this curve usually moves up.

When the yield curve begins to move downwards, investors start to have fear about higher interest rates. In case the yield curve inverts, it will mean that chances of a recession will be higher.

Interest Rates

In the past years, the Federal Reserve has been in a tightening mood. The bank has tightened by 25 basis points once per quarter. In the past, most recessions have happened at a period when the Federal Reserve is tightening.

Mergers and Acquisitions

Mergers and Acquisitions (M&A) are indirect indicators of recession. In M&A, large companies usually acquire the smaller ones.

In recent years, the number and size of deals have increased. For example, Dow and Dupont have merged, Microsoft has acquired LinkedIn, Amazon has acquired Wholefoods, and IBM has announced that it will acquire Red Hat.

The size of deals is currently at all time highs. They have been fueled by low interest rates and the tax cuts. When they happen in large numbers, they can point to more pain in the market as the deals starts to disappoint.

Economic Data

In months before a recession happens, the economic data tends to start disappointing. In recent months, data from the developed countries have been disappointing. This is more important in the US where the housing market has started cooling down.

Similarly, inflation, jobs, consumer confidence, and manufacturing data has been cooling down. The same is true in Europe, China, Japan, and other developed countries. At the same time, the emerging markets are not at ease as higher interest rates raise their borrowing costs.

How to stay protected

While no one can predict accurately when a recession will happen, these numbers are important and should be taken seriously.

As a trader, you will not be affected a lot by a financial crisis. This is because you make money by making short-term trades in diverse assets like stocks and currencies. You are not an investor, who stays invested at all times.

Still, to protect yourself from the adverse effects of a global meltdown, you need to practice safe trading, which means being less over-leveraged and always having a stop loss on all your trades.

As a trader, you should do also the following. First, you should avoid overnight trades. Second, you should size your trades appropriately. Third, you should have a stop loss for all your trades.

Now that you know what causes recessions and how to protect your money, learn how you can make money with your Trading Office even during a recession.

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