Forex Investment and Currency Trading

“Real Effective Exchange Rates” (REER) offer an alternative measure of longrun valuation. However, they must be interpreted with caution, as they can deliver messages significantly at odds with the near-term trading environment, just like many longer-run valuation metrics. REERs currently imply that the EUR could still have some way to fall, but JPY is also overvalued, and GBP is undervalued at the moment. Indeed, REERs offer a guiding point toward the longer run, but substantial differences can persist for extended periods.

Nevertheless, simply looking at REERs can also give another estimate of how distant exchange rates are from equilibrium, even if divergence from that equilibrium can be highly persistent. REERs are simply exchange rate indices that take into account both different trade patterns and inflation rates. In some cases, they will not behave much differently to an important bilateral exchange rate; for example, the Canada REER moves very similarly to USD-CAD for two reasons: (1) because the U.S. is the dominant Canadian trading partner (the U.S. is around two-thirds of Canada’s total trade), and (2) since the passage of inflation targeting by the Bank of Canada, U.S. and Canadian inflation rates have not been very different. Consequently, the Canadian REER and USD-CAD are very similar.

JPY provides a useful case study in which REERs provide an important insight. The strengthening of JPY versus USD led to market concern around the start of the financial crisis about the risk of currency intervention on the order of what took place in 2003-04. But for most of the crisis, the REER for Japan was considerably lower than it was in 2003-04, even as JPY initially ascended toward the 100 mark, since Japan is now much less U.S.-focused in its trade patterns and has a higher Asia component. Only recently has the JPY REER reverted to 2003-04 levels, and so now we look out for the start of intervention risks should JPY move higher from here into the low 80s range.

In the long run, we would expect REERs not to have a long-run trend because it is a relative real price. If a country’s REER really did trade permanently higher, then over time that country could swallow up everyone else’s goods as its standard of living persistently rises relative to other countries. However, the measure of that long-run average index is an arbitrary one, and the chief practical issue is to take a time span long enough to try to filter out fluctuations. Fortunately, taking the time horizon does not matter too significantly between most countries.

USD is now roughly at fair value, with a current valuation of +2 to -2% depending on the time horizon for averaging the data. In contrast, EUR and JPY are too strong, while GBP is very weak. Of course, such conclusions from REERs are why it is crucial to distinguish between short- and medium-term trading suggestions and longer-run equilibrium profiles.

The time horizon does make a non-trivial difference with the SEK, which went through a massive currency crisis back in the early 1990s. Depending on how far back REER is calculated, SEK is either 11% or 22% undervalued. JPY shows a smaller difference, but, on a REER basis, there is anywhere from a 4% to 12% undervaluation.

Some analysts are subjectively more comfortable with the calculation that goes back to the 1980s, as inflation behavior around the world was decidedly more volatile before then. However, generally, the selection of time period does not make as crucial a difference.