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

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 Great Graphic 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
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
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. 

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