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How a year of NAFTA news affected exchange rates

Markets overshoot in the short term

Exchange rates are among the most volatile macro series. When allowed to float, exchange rates are much more responsive to news and shocks than interest rates or the prices of goods and services. They are volatile at lower frequencies (e.g., monthly and quarterly) but especially volatile at higher frequencies (e.g., hourly, daily, or weekly). Moreover, exchange rates tend to “overshoot,” with much stronger responses to news and shocks in the short term than in the medium and long terms. This behavior, which is the opposite of Paul Samuelson’s Le Chatelier’s principle, was first formalized by Rudiger Dornbusch more than forty years ago.

A relevant example is the recent exchange rate behavior for Mexico and Canada, two of the U.S.’s main trading partners. The graph shows the daily exchange rate of the Mexican peso (left axis) and the Canadian dollar (right axis) in terms of U.S. dollars. And the three vertical lines identify three recent U.S. events: election day (Nov. 8, 2016) in green, inauguration day (Jan. 20, 2017) in purple, and the day the president announced his intention to renegotiate NAFTA (April 27, 2017) in blue.

During the recent presidential campaign, the Republican candidate clearly and ardently advocated restraining some international trade in general and terminating NAFTA specifically. However, the dominant view (both within the U.S. and worldwide) was that the Democratic candidate would win the election. The 2016 election result was a surprise for most observers and, as argued here, for investors as well. Between Tuesday, Nov. 8, and Thursday, Nov. 10, there’s a clear and significant jump in the peso-to-dollar exchange rate: from 18.435 pesos per U.S. dollar to 20.493. That’s more than 10% in just a few hours. The Canadian dollar also depreciated, but only about 1.3%, from 1.333 to 1.347. The responses of these exchange rates seem to suggest that, on Nov. 8, investors took seriously the prospect that NAFTA would be terminated or renegotiated and that such a change could reduce the value of investments in Mexico.

After the election, both exchange rates stabilized and even moved downward. However, the Mexican peso began a bumpy ride: It depreciated significantly, peaking on Jan. 20, 2017, the date the new administration took office. The peso then appreciated continuously but only until April, when the president used Twitter to announce his inclinations to terminate NAFTA. This position was reinforced by the fact that the U.S. also imposed preliminary countervailing duties on Canadian imports of softwood. Both the peso and the Canadian dollar depreciated with respect to the U.S. dollar. On April 27, 2017, the president announced his intention to renegotiate NAFTA. Eventually, both currencies appreciated.

Since September, though, both currencies have depreciated: 5% for the Canadian dollar and 9% for the Mexican peso. Two factors may be at work: a potential increase in U.S. interest rates and the news that renegotiating NAFTA has proven to be very difficult for all three countries.

How to make this graph: Search for the daily series of the Mexican peso exchange rate: DEXMXUS. From the “Edit Graph” menu, choose “Add Series” and search for the similar Canadian dollar exchange rate: DEXCAUS. From the “Format” menu, select the right axis for the Canadian exchange rate. In both series, select 3 for the line width. To create the vertical lines, open the “Add Line” tab and select “user-defined line”: Enter the date you want for both the start and end dates, and use values to fill most of the vertical space. (By the way, the exchange rates aren’t tracked on holidays or weekends, so there are some blank segments in the series.)

Suggested by Alexander Monge-Naranjo.

View on FRED, series used in this post: DEXCAUS, DEXMXUS

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