First time I am doing this, but I guess it can be fun.
We discussed this Pound/US dollar spot curve in macro this week. Send me in DM your interpretation of this spot curve - if one is good it will be published. Otherwise, I will just post what we discussed in class.
Please find below another graph that might help you.
Good luck
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Thanks a lot to the few who sent an answer !! - I will publish mine as most answers were incomplete (the question was probably a bit hard).
First thing first, we define the nominal exchange rate as the domestic price of the foreign currency.
The second thing to comment is the graph of the relative monetary base and the exchange rate. Why did I include this graph ? I included it for you to spot that movement in exchange rates are often very difficult to anticipate and at first sight uncorrelated to macroeconomic fundamentals.
To evaluate the link between exchange rate movements and macroeconomics fundamentals, the comparison between the relative monetary base and exchange rates makes sense as if you want to compare exchange rates to macro fundamentals, a logic variable to do so is the monetary base. Indeed, in the long run, the monetary base affects prices and hence the exchange rates.
A good comment to add is that a comparison of money supplies across the 2 countries would have been better - as money supply is the actual variable that directly influences the price level. However, the definitions of the money supply in the UK & the US are different and, therefore, incomparable. Note that even the monetary base is not published by the BoE anymore.
Lastly, the high volatility of the monetary base since 2016 can be explained by the beginning of Quantitative Easing (QE).
Commenting on the actual graph:
The things to spot:
- On the 2nd of Feb: Both CBs increase their policy rate by 50 basis points -- no big movements in exchange rates that day
- Big depreciation of the US$ from the 3rd Jan - 20th Jan
- 3rd Feb: appreciation of the US$
-15 Feb: appreciation of the US$
Main conclusion: It is not the actual monetary policies that are driving the exchange rates. Instead, it is the news about macroeconomic fundamentals that make people adjust their expectations.
In this example:
- There was no big movement on the 2nd of Feb because both increase in policy rates were expected by financial markets and , consequently, already priced in.
- The big depreciation of the US$ between the 3rd and the 20th of January reflects the expectations that the US was not going to tighten monetary policy as much as previously anticipated in the next months / few years.
- 3rd Feb: Big news in the US job markets with a half a million job surge in January. Expectations that the Fed might have to raise rates further, leading to an appreciation of the US $.
- 15 Feb: higher than expected retail sales in the US which also made markets believe that the Fed might have to further rise rates
And that was it :) I might do that again in the future so be ready !