A year ago most economists predicted the US would fall into recession in 2023: the solid near-3% GDP growth outturn makes this ‘miss’ one of the worst in a long trail of past errors. Part of the reason may be that the old-fashioned business cycle based on waves of new capital spending is less important, as evidenced by the growing disconnect between the inverted US Treasury yield curve and a still buoyant US domestic economy. Our thinking needs to be updated.
Consider instead an international financial cycle based on liquidity and driven by the need to refinance debt. The underlying Global Liquidity cycle fluctuates with a periodicity determined by the average 5/6-year debt maturity profile in much the same way that capital spending moved at a frequency governed by the average 10-year depreciation pattern of fixed capital.
This liquidity-driven cycle is increasingly viewed by investors through the binary lens of ‘risk on’ and ‘risk off’. This forces us to understand how investors’ risk appetites change. Specifically, it demands a closer look at risk premia in bond and equity markets. For bonds, this requires digging into the interest rate term structure.
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