Credit Cycles Explained | CFA Level I Economics

In this short lesson, we’ll quickly dive into the concept of credit cycles and how they relate to business cycles.

Understanding Credit Cycles

We’ve learned about business cycles in a previous lesson, which uses GDP as a measure of economic activity. On the other hand, credit cycles refer to cyclical fluctuations in interest rates and the availability of loans. The bottom of the cycle is characterized by high interest rates and low availability of loans, while the peak of the cycle features low interest rates and wide availability of loans. The two cycles are intertwined:

• Lenders are more willing to lend and tend to offer lower interest rates during economic expansions.
• Lenders are less willing to lend and require higher interest rates when the economy is contracting.

The effect goes the other way as well. When credit is cheap and widely available, asset bubbles can form, particularly in the equity and property market. When credit subsequently tightens and gets more expensive, asset prices plunge and lead to a domino effect of defaults. Research suggests that when the directions of the business cycle coincide with the directions of the credit cycles, economic expansions tend to be stronger, and contractions are deeper and longer.

Credit Cycles vs. Business Cycles

However, be aware that the directions of the two cycles may not always coincide. Research suggests that credit cycles tend to be longer in duration than business cycles. For example, there were two economic cycles for the US economy in a specific period, marked by the dot-com bubble and the global financial crisis, but just one credit cycle within the same period. When the expansion in credit coincided with economic expansion after the dot-com bubble, the economic expansion was strong. But the subsequent recession was made much deeper and longer as it coincided with the credit tightening cycle.

Investment Decisions and Credit Cycles

Some investors may study the stage of the credit cycle to guide investment decisions:

1. It helps explain if a boom in real estate prices is a consequence of excessive credit.
2. It helps investors assess the likelihood of a recession. In many past recessions, long periods of excessive credit that coincide with an economic boom tend to result in a recession that was preceded by a tightening of credit.