You Know what Happened to Nominal Exchange Rates, but What about Effective Exchange Rates?

Newton's cradle concept on background marc

As investors and traders, we are familiar with the developments in the foreign exchange market.  In the year-to-date, the yen has gained 1.8% against the US dollar, while the euro has fallen nearly 4.5% and sterling is off by 16.3%.  These are bilateral and nominal exchange rates.

They are important to us.  It determines the return on our foreign investment.  It is what we use for hedging.  It is what determines how much money we need for that foreign vacation, or what that book from London costs compared to buying it locally.

 

However, from policymakers point of view, the bilateral nominal rate is not sufficient for comprehending the economic impact of the exchange rate movement.  For this policymakers will look at an effective exchange rate.  It a trade-weighted index.  This means, for example, that how the dollar performs against Canada and Mexico will have a greater impact on the US economy than how the dollar performs against Australia and South Korea, whose economies are roughly equivalent.

The Bank of England provides effective exchange rates indices and updates them daily.  Their data is available on Bloomberg, from where the chart below made.  It depicts the performance since the start of the year for four major currencies.  The yen (white) appreciated, but stalled in September and returned to almost where it began the year.  Om this effective exchange rate basis, it is up about 4.2% this year.  It had been up nearly 20%.  Japan exports only about 15% of GDP.  The appreciation of the effective exchange rate like has a minimal direct impact.  The indirect impact, such as the cost of volatility, needs to be included in a thorough analysis.

The euro (yellow line)’s effective exchange rate has been firm this year.  It did not peak until October and November when it was about 10% above where it had begun the year.  Since then, while nominal bilateral exchange rate against the dollar has fallen to new lows since 2003, the effective exchange rate has unwound most of the year’s appreciation but is still up a little more than 2%.

The US dollar’s effective exchange rate (green line) weakened in the well into Q3.  At its most, it was off about 8%, but since August, it has appreciated strongly.  It is now up to a little more than 1.0% on the year.  It terms of economic impact, the net movement is too small.  While the dollar is a factor the Fed integrates into its formulation of policy; our understanding is that it is the rate of change that may be more significant than level.  The Federal Reserve’s own real broad trade-weighted index of the dollar appreciated about 2.6% in the first 11 months of the year.  This does not sound worrisome. However, in annualized pace of the last three months (Sept-Nov) is nearly 17%.  If sustained, this pace may help steady the Fed’s hand in the first part of the new year.

Sterling (fuchsia) had trended gently lower until the leg down in response to the referendum in late June.  It the effective exchange rate found a base about 15% lower than it began the year in Q3, before taking another leg lower in October.  It appreciated, seemingly partly as a result of ideas/hopes of an amicable divorce, and a retreat in the euro.  That appreciation appears to have lost momentum since the start of the month in the face of new and broad dollar strength and what appears to be record large US interest rate premiums over the UK (in both the two-year and 10-year yields).

 

We extended our short study to include the Chinese yuan as well. The yuan has depreciated by 6.6% against the US dollar this year.  The chart below was created on Bloomberg to show the Bank for International Settlements’ effective exchange rate for the yuan since 2005.  It rose by about 57.6% through its peak that it was near as recently as this past February.  Since then the depreciation on the BIS index matches its decline against the dollar (~6.5%).  Note, however, that the trend since 2005 remains intact.  It overshot to the upside from mid-2014 through February 2015.  The recent decline unwound the overshoot without breaking the trend.

 

The People’s Bank of China says that it monitors the yuan against a particular basket (CFETS). Against this basket, the yuan fell about 6.75% from the end of 2015 to August and September.  It has since recovered a little and was off about 5.8% as of the end of last week.  In the first three days of this week, it is up a minor 0.1%, which still makes it among the few currencies that have appreciated against the dollar this week.

The yuan’s depreciation is notable, though it seems too small to have a significant economic impact or a sign that Chinese officials are embarking on a depreciation course.  Indeed, according to the BIS real equilibrium exchange rate measure, the yuan is fairly valued (~1% rich). The euro and yen have edged slightly higher on their effective trade-weighted measures. Sterling’s depreciation is significant. Between that and actions by the central bank, the UK got a large dose of monetary stimulus.