Today, I want to talk to you about something that I've never discussed before with my readers. It's how the business cycle affects the carry trade.

Savvy stock investors watch the business cycle and know what's going on and what sectors of the economy benefit at what point in the cycle. They also notice when the whole economy turns up or down by watching this cycle.

So let's talk more about this so that you can find out how it affects the carry trade (especially ones like EUR/JPY).

The business cycle looks like the waves in the ocean. While there are five stages, the economy is basically either expanding or contracting. The five stages are just a part of those processes along with their transition phases.

The five stages are: recession (economic contraction), trough, recovery, growth (economic expansion), and the peak.

During an economic growth cycle, businesses produce more goods and invest in more machinery and technology while consumers spend more money because they are confident in their future and thus the overall economy.

Less is spent by the government on unemployment benefits and more money is collected in income taxes from consumers who are earning more through raises and bonuses while businesses are making more profit. Prices also tend to increase overall during an expansionary period.

During an economic contraction, business output slows due to a reduction in demand, and some businesses go bankrupt. Consumer confidence begins to suffer as layoffs become widespread. Unemployment increases, firms reduce investment, banks tighten lending, and consumers start to save more rather than spend.

The government is forced to spend more on unemployment benefits while less money is collected in taxes. Also prices of goods and services generally start to fall from a lack of demand.

The average economic boom lasts approximately 3.4 to 3.7 years.

Economic recessions and contractions, in comparison, tend to last anywhere from 13.1 to 18.5 months. (The Great Depression was an exception and lasted 43 months). Recessions don't generally last nearly as long as the boom times, but they feel twice as long when you are living through them.

How in the world can the "average Joe" know when a new economic cycle starts? The National Bureau of Economic Research officially makes that announcement.

You can also watch for the GDP data that comes out to get a ballpark time horizon before the federal government officially announces that a recession has begun. For the most part, when you get two consecutive quarters of negative GDP growth, the economy is in a recession.

Why do we have business cycles? Because the Fed lowers and raises interest rates, pumps money into the economy and withdraws money from the money supply. Some may not agree with that, but that's why.

What causes businesses to prosper is when their real rate of return greatly exceeds that of the interest rate at which they can borrow. However, as an economy heats up, the Fed wants to slow it down so inflation doesn't get out of hand. They do this by raising interest rates.

When rates are rising, corporate profits are eventually squeezed. This added expense weighs down on consumers and businesses and starts to cause even more erosion in corporate profits. As the profit margins narrow and the overall interest rate increases, profits become almost an impossibility and businesses contract.

In the meantime, consumers are licking their wounds from layoffs and the unemployment lines.

Businesses aren't able to flourish again until interest rates come down sufficiently to where they can make enough money over their borrowing costs. As those margins expand in the businesses' favor, the economy picks up, hiring resumes and we have economic expansion.

So how does all of this affect carry trades? As businesses flourish, it shows up in their stock prices. As investors feel confident enough to buy up stocks, they also buy up high-yielding currencies at the same time.

This causes these carry trades to go along for the ride with stocks. Many traders call this being in risk-seeking mode because investors are willing to take on risk for above average returns.

When investors are in a risk-adverse mode, they go into defensive posture and forgo risky assets like stocks or carry trades for Treasuries (bonds) and low-yielding currencies.

About four to six months before businesses perk up, stocks start to gain. So you could say that stocks start to head higher in the trough of the economic cycle. That's because stock prices are still at suppressed values, and mutual fund and hedge fund managers want to snatch these up while the bargains are still to be had.

After all, if they wait until it's obvious to everyone that the economy is perking up, then all of the discounted value already will be realized and out of the stock price by that time. This is why stocks preemptively head higher about four to six months before businesses really start to improve as a whole.

When stocks finally firm up, inevitably the carry trades do too. When stocks stabilize, volatility dies down in every market, generally. When it does, it provides the right environment for carry trading, which is a low-volatile, stable environment.

If the latest recession started in March, we should be pulling out of this in the stock market sometime between January and July 2009. As this happens, it should put a floor under carry trades and give then some banner years as before.

So, get ready for the next boom in the coming months. When stocks get their solid footing once again, it will be time to buy carry trades like EUR/JPY and GBP/JPY once again.