ForexFundamental Analysis

Understanding the Indirect Effects of Exchange Rates

The average person experiences the value of currency as fairly stable from day to day. The price of a cup of coffee every morning is around $1.50, the fixed-interest car payment and mortgage are the same every month, and for a salaried worker, even the  paychecks are identical. The fact that the value of currency is constantly fluctuating in relation to other currencies only seems to matter for most people when planning a foreign trip or making an internet purchase from a foreign website. This limited view, however, is mistaken.

The indirect impact of exchange rates and their fluctuations extends much more broadly and deeper in ways that affect several of the most important aspects of our economic lives—like how long it takes to get a job, where we can afford to live, and when we can retire. Exchange rates have a tremendous influence on the economy both in the near term and over prolonged periods of time.

Exchange Rates and What You Pay for Goods
In this era of globalization, goods from other countries are as commonplace, or sometimes even more commonplace, than those produced domestically. Exchange rates have a significant impact on the prices you pay for imported products. A weaker domestic currency means that the price you pay for foreign goods will generally rise significantly. As a corollary, a stronger domestic currency may reduce the prices of foreign goods to some extent.

Let’s illustrate the impact of a weaker domestic currency on product prices with an example. Assume that the Canadian dollar (C$) declines by 10 percent against the U.S. dollar (US$) over the period of a year, from a rate of 90 U.S. cents per C$ (US$1 = C$ 1.1110) to 81 U.S. cents (US$1 = C$1.2350). What would be the price change in Canadian supermarkets for a pound of California almonds that are available in the U.S. for US$7? All else being equal (assuming no other costs and only taking exchange rates into account), the price of California almonds in Canada would increase from about C$7.78 (i.e., approx. US$7 x 1.1110) to C$8.65 (US$7 x 1.2350) per pound.

As another example, let’s look at a real-world effect of currencies and prices when more than one country is involved. In particular consider when the euro tumbled 21.4 percent against the U.S. dollar in the 12-month period leading up to April 24, 2015. During the same time, the Canadian dollar had declined only 9.5 percent against the U.S. dollar, by comparison. As a result, the Canadian dollar had appreciated about 15 percent against the euro over the past year (from C$1 = EUR 0.6575 to C$1 = 0.7560), resulting in Canadians paying somewhat lower prices for European products such as wine and cheese.

The change in the price of imported products depends on how the currencies of the exporting nations (i.e., those from where these products have been sourced) have fared against the domestic currency. Through the 2010’s the U.S. dollar has reigned supreme against most major currencies, which resulted in American consumers paying relatively lower prices for imports such as German automobiles or Japanese electronics.

Exchange Rates, Inflation and Interest Rates
A weak domestic currency can push up the inflation rate in a nation that is a big importer, because of higher prices for foreign products. This may induce the central bank to raise interest rates to counter inflation, as well as to support the currency and prevent it from plunging sharply. Conversely, a strong currency depresses inflation and exerts a drag on the economy that is tantamount to tight monetary policy. In response, a nation’s central bank may move to keep interest rates low or reduce them further so as to preclude the domestic currency from getting too strong.

The exchange rate thus has an indirect impact on the interest rate you pay on your mortgage or car loan, or the interest you receive on the money in your savings or money market account.

Exchange Rates and the Job Market
A weak domestic currency spurs economic growth by boosting exports and making imports more expensive (forcing consumers to buy domestic goods). Faster economic growth usually translates into better employment prospects. A strong domestic currency can have the opposite effect, as it slows economic growth and curtails employment prospects.

Exchange Rates and Investments
Exchange rate fluctuations can have a substantial impact on your investment portfolio, even if you only hold domestic investments. For example, the strong dollar generally dampens global demand for commodities as they are priced in dollars. This lower demand can affect earnings and valuations for domestic commodity producers, although part of the negative impact would be mitigated by the weaker local currency.

A strong currency can also have an effect on sales and profits earned overseas; in recent years, numerous U.S. multinationals attributed a hit to the top-line and bottom-line due to a stronger dollar. Of course, the effect of exchange rates on portfolio returns is well known. Investing in securities that are denominated in an appreciating currency can boost total returns, while investing in securities denominated in a depreciating currency can trim total returns. For instance, a number of European stock indices reached record highs in the first four months of 2015 back when the dollar was strengthening quite aggressively, but American investors who had invested in those shares would have actually seen their returns reduced substantially by the plunging euro.

Exchange Rates and Real Estate
A weak or undervalued domestic currency can be like having open-ended Black Friday sale and what is marked down is every single good, service, and asset in the country. The trick is, only buyers who can pay in the stronger foreign currency get the sale price. This attracts foreign tourists, which can be good for the economy. However, it also attracts foreign buyers looking to scoop up cheap assets and outbidding domestic buyers for them.

Foreign buyers have pushed up housing prices in nations with a weak currency. Imagine you are house hunting and suddenly you are bidding against people who are getting, say, an automatic 30 percent discount on the asking price. Even if you are not house hunting, high housing prices and low supply affect rent as well. In the past decade, local demand for housing has also been very robust in numerous nations, as their central banks held interest rates at record lows in a bid to stimulate their economies. This also had the effect of pushing their currencies to multiyear lows, raising fears of a global currency war.

In Summary
Just like an iceberg, the major impact of exchange rates fluctuations lie largely beneath the surface. The indirect effect of currency fluctuations dwarfs the direct effect because of the huge influence it exerts on the economy in both the near term and long term. The indirect effect of exchange rates extends to the prices you pay at the supermarket, the interest rates on your loans and savings, the returns on your investment portfolio, your job prospects, and possibly even on housing prices in your area.

Elvis Picardo can be contacted on this link: Elvis Picardo

Elvis Picardo is a protfolio manager at Luft Financial, a division of HollisWealth in Canada. He has more than 15 years of experience as an analyst and market strategist., with numerous successful stock recommendations and investment strategies to his credit over this period.

He brings a global perspective to investment research and portfolio management, obtained through two decades of international capital markets experience across a broad spectrum of asset classes, including equities, fixed income, options, and currencies. Elvis holds the Certified Investment Manager designation, a Graduate Degree in Engineering and a Master's Degree in Management Studies.

Elvis Picardo is a protfolio manager at Luft Financial, a division of HollisWealth in Canada. He has more than 15 years of experience as an analyst an...