Trading the FX markets is all about exchange rates. For a clear understanding of what an exchange rate is, think of it as showing the value of one currency in terms of another. The professional FX market also uses conventions for different exchange rates on the basis of which currency is the base – domestic or foreign? However, for the retail trader, the definition mentioned above contains everything they need to know about an exchange rate.
Besides the exchange rate, like the one expressed for the EURUSD, there are also nominal or trade-weighted exchanges. For instance, the European Central Bank (ECB) calculates and publishes the EER – a nominal effective exchange rate. This rate is nothing but a weighted geometric average on exchange rates with various trading partners that the Euro area has.
The chart below shows the differences, albeit slight ones, between the two – the EURUSD exchange rate and the EER, or the trade-weighted EUR. Out of the two, the latter is far more important for the ECB, although few traders are aware of its existence.
Trade-Weighted EUR – A Concern for the ECB
One of the striking facts on the chart above is the sharp appreciation of the EUR during the coronavirus pandemic. A stronger currency favors imports because the domestic population perceives goods and services from abroad as cheaper. On the other hand, a weaker currency favors exports. As such, policymakers use the two key concepts when setting the policy in the region.
The problem comes from the domestic saving rate. Typically during a crisis, the savings rate increases. One of the first things the ECB did during the economic contraction was to ease the conditions further. However, so did the Fed and other central banks, and both the EURUSD exchange rate and the trade-weighted EUR appreciated.
When the EURUSD exchange rate reached 1.20, the ECB intervened verbally. From that moment on, the strength of the Euro became an integrating part of the introductory statement.
The ECB is right to be concerned. That is especially true in the case of the trade-weighted EUR. The EER-40 reflects the foreign currencies against the EUR geometric average. The top-ten of those currencies has a larger weight in the trade-weighted EUR. After the U.K., the U.S. and the USD top the list. Hence, the ECB’s concern about the strength of the EURUSD makes sense because it affects what matters the most for the ECB – the trade-weighted EUR.