Forex RouteMap: Real Effective Exchange Rate

Buy when the coloured lines are low, sell when they are high

Sample chart showing over- or under-valuation based on real effective exchange rates as calculated by ourselves. Change from yellow to orange indicates projection based on inflation.

This strategy indicates whether currencies represent good or bad value at current exchange rates. It is designed to highlight currency cycles that are ultimately self-correcting owing to lagged effects of the balance of payments on real effective exchange rates, that is to say the trade-weighted exchange rate adjusted for comparative inflation rates, as calculated by ourselves.
 
For comparability, exchange rates have been rebased to set year-end 1994 at 100. In each chart the exchange rate is shown as the thick white line on the right hand axis. The explanatory variables use the left hand axis. The real effective exchange rate based on comparative consumer prices is the thin yellow line and that based on comparative unit wage costs is the green line. 
 
Best Guesses, shown as the orange line (or the pink line), suggest what would happen to the valuation ratio based on forecasts for inflation both at home and among the main trading partners, assuming constant exchange rates. The base level is the average for the last completed calendar year. Forecasts are based on consensus estimates for inflation, using the weights in the PIT family of real effective exchange rates.
 
These real effective exchange rates are a set of proprietary indices calculated by PIT, based on consumer price indices and mutual trade between all countries in the database using an average of imports and export weights, which have been rebalanced every five years, described as REEF (CPI). The most important trading partners are used in the calculation for each country. These include the Euro-Zone countries and up to six other major partners, representing on average some two-thirds of mutual trade.
 
Where available, an additional set of calculations has been made on the basis of unit wage costs rather than consumer prices, described as REEF (Unit Costs). Theoretically, this is a more appropriate measure of competitiveness. However in practice the source data on wage levels is not produced in some countries, in others the governmental data is of doubtful quality and there are also differences in the definitions that may create distortions.
 
Please note that owing to structural changes in the economy of a country over time, there may be a misleading tendency for the rate to drift upwards or downwards over the long-term, whereas it should be expected to fluctuate around a horizontal plane.
 
Owing to the conversion of legacy currencies into Euros, analysis is provided on the common currency, rather than for individual countries. Trade between members of the Euro-Zone has been excluded. Historical data is provided by creating synthetic GDP-weighted time-series for the component currencies, expressed in the European Currency Unit.


This strategy is naturally self-correcting but may experience extreme swings before the J-curve corrects, as shown by the bull markets in the US$ in 1985 and 2000