How Undervalued is the U.S. Dollar?

Last updated 10/12/2009 9:49 AM ET (GMT -5) 14 Comments

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Kathy Lien

Director of Currency Research, GFT

Since the beginning of the year, the U.S. dollar has weakened dramatically. Not only has it become the whipping boy of the financial markets but there is a good chance that it could be headed lower. On this quiet Columbus Day Holiday with no U.S. economic data on the calendar, the weakness of the dollar is the central focus of both financial print and visual media. We have talked at length about why we believe the dollar could continue to fall using arguments such as the Federal Reserve’s lack of urgency to remove monetary stimulus, the outlook for the labor market, the twin deficits, protectionism, reserve diversification and risk appetite. However with this in mind, we still believe that the dollar is due a relief rally particularly since short dollar positions have hit extreme levels. Therefore we take this opportunity to talk about the degree of the dollar’s undervaluation against the major currencies and what that could mean for the foreign exchange market in the days ahead.

Despite the fact that the Australian and New Zealand dollars have appreciated more than 25 percent against the U.S. dollar since January, they are not necessarily the most overvalued currencies on a purchasing power parity basis (PPP). Of the 7 major currencies, the Swiss Franc and the Euro are the most overvalued against the dollar which by the same token means that the dollar is the most undervalued against these currencies. The least overvalued are the British pound and Japanese Yen (we categorize the degree of overvaluation by taking the average of the 3 PPP models). Although PPP certainly has its limitations, it provides us with context. For example, the current valuation of the dollar suggests that even though the Australian and New Zealand dollars have appreciated the most against the greenback this year, it may have more room to run than the Swiss Franc and Euro.

What is Purchasing Power Parity?

Purchasing power parity is based on the idea that foreign exchange rates are determined by the relative prices of a similar basket of goods between 2 countries. In other words, a Big Mac in the US should cost the same as a Big Mac in the UK once exchange rates are accounted for. PPP has its faults as it assumes that goods can be traded easily without regard to such things as tariffs, quotas and taxes. It is also a long term way of valuing exchange rates and does not take into consider shorter term factors.

Nonetheless, PPP gives us context when looking at the current valuation of various currencies against the US dollar. There are 3 publicly available sources for purchasing power parities – Bloomberg’s PPP calculation using consumer prices, the Economists’ PPP calculation that compares the price of Big Macs around the world and the OECD’s PPP data. The reason why the PPP values are not consistent is because different methods of calculation and different baskets of goods used to compare prices will arrive at different PPP rates.

More on Purchasing Power Parity

PPP’s Basket of Goods

The basket of goods and services priced for the PPP exercise is a sample of all goods and services covered by gross domestic product (GDP). It includes consumer goods and services, government services, equipment goods, and construction projects. More specifically, consumer items include food, beverages, tobacco, clothing, footwear, rents, water supply, gas, electricity, medical goods and services, furniture and furnishings, household appliances, personal transport equipment, fuel, transport services, recreational equipment, recreational and cultural services, telephone services, education services, goods and services for personal care and household operation, and repair and maintenance services.

Big Mac Index

One of the most famous examples of PPP is the Economist’s Big Mac Index. The Big Mac PPP is the exchange rate that would leave hamburgers costing the same in the United States as elsewhere, comparing these with actual rates signals if a currency is under or overvalued. For example, consider that the exchange rate between the United States and Canada is 1.57. In the United States a Big Mac cost $2.49. In Canada, a Big Mac cost $3.33 in local Canadian dollars (CAD), which works out to only $2.12 in U.S. dollars. Therefore, in this case the exchange rate for USD/CAD is overvalued by 15 percent using this theory and should be only 1.34.

OECD Purchasing Power Parity Index

A more formal index is put out by the Organization for Economic Cooperation and Development. Under a joint OECD-Eurostat PPP program, the OECD and Eurostat share the responsibility for calculating PPPs. This latest information on which currencies are under- or overvalued against the U.S. dollar can be found on the OECD’s web site at www.oecd.org. The OECD publishes a table that shows the price levels for the major industrialized countries. Each column states the number of specified monetary units needed in each of the countries listed to buy the same representative basket of consumer goods and services. In each case the representative basket costs 100 units in the country whose currency is specified. The chart that is then created compares the PPP of a currency with its actual exchange rate. The chart is updated weekly to reflect the current exchange rate. It is also updated about twice a year to reflect new estimates of PPP. The PPP estimates are taken from studies carried out by the OECD; however, they should not be taken as definitive. Different methods of calculation will arrive at different PPP rates.

Limitations to Using Purchasing Power Parity

PPP theory should be used only for long-term fundamental analysis. The economic forces behind PPP will eventually equalize the purchasing power of currencies. However, this can take many years. A time horizon of 5 to 10 years is typical. PPP’s major weakness is that it assumes goods can be traded easily, without regard to such things as tariffs, quotas, or taxes. For example, when the United States announces new tariffs on imports the cost of domestic manufactured goods goes up; but those increases will not be reflected in the U.S. PPP tables.

There are other factors that must also be considered when weighing PPP: inflation, interest rate differentials, economic releases/reports, asset markets, trade flows, and political developments. Indeed, PPP is just one of several theories traders should use when determining exchange rates

Comments (14)

davidh

October 12, 2009 at 04:46 PM ET

Thans a lot Kathy for such valuable information.

d

October 12, 2009 at 11:56 AM ET

I have searched for the chart referenced on www.oecd.org. However I am unable to find this. Can you provide a more specific link?

klien

October 12, 2009 at 11:57 AM ET

http://www.oecd.org/department/0,3355,en_2649_34357_1_1_1_1_1,00.html

okpasha

October 12, 2009 at 12:25 PM ET

For us newbies to forex please can you give us some links to or advice as to how we can make this informative article tradeable as to when these respective currencies/government might raise or lower there rates. Thanks.

klien

October 12, 2009 at 12:34 PM ET

Perhaps you missed the part that I said "For example, the current valuation of the dollar suggests that even though the Australian and New Zealand dollars have appreciated the most against the greenback this year, it may have more room to run than the Swiss Franc and Euro. "

peterlitch

October 12, 2009 at 09:50 PM ET

oecd says" that an overvalued currency tends to have account deficits"so if you take money from Peter to pay Paul but they are of the same household, to me then when the /yeast comes out of the bread/ the lifeless doe hits the table about the same time as the noble prize, funny i can here that same noble thing at the other side of this.

Junior

October 12, 2009 at 10:35 PM ET

Hi Kathy,
How important do you think the PPP is to the market? As you say, it is a long term thing due to limitations, so the way I see it, while it might drift somewhat towards what could be seen as equilibrium, with the volatility in the market, and the way the PPP is likely to move, its never going to reach it. While it is fascinating in an economic sense, how relevant do you think this is to fx trading? I ask because I often hear people say a currency is overvalued, but we still see it gaining and it doesn't really seem to mean anything to the currency markets.
Cheers.

klien

October 13, 2009 at 09:43 AM ET

I think the only value is the context that it provides. First, from this chart we can understand why the SNB is so concerned about the strength of its currency and why they have been the only one to physically intervene. Second, the chart tells us that the AUD/USD and NZD/USD may have more room to run and if someone was to step in to stem their currency's slide, it would probably be the ECB before the RBA. Hope that helps!

klien

October 13, 2009 at 09:43 AM ET

I think the only value is the context that it provides. First, from this chart we can understand why the SNB is so concerned about the strength of its currency and why they have been the only one to physically intervene. Second, the chart tells us that the AUD/USD and NZD/USD may have more room to run and if someone was to step in to stem their currency's slide, it would probably be the ECB before the RBA. Hope that helps!

klien

October 13, 2009 at 09:43 AM ET

I think the only value is the context that it provides. First, from this chart we can understand why the SNB is so concerned about the strength of its currency and why they have been the only one to physically intervene. Second, the chart tells us that the AUD/USD and NZD/USD may have more room to run and if someone was to step in to stem their currency's slide, it would probably be the ECB before the RBA. Hope that helps!

klien

October 13, 2009 at 09:44 AM ET

I think the only value is the context that it provides. First, from this chart we can understand why the SNB is so concerned about the strength of its currency and why they have been the only one to physically intervene. Second, the chart tells us that the AUD/USD and NZD/USD may have more room to run and if someone was to step in to stem their currency's slide, it would probably be the ECB before the RBA. Hope that helps!

StLForextrader

October 12, 2009 at 01:07 PM ET

Thanks for your interesting and informative article. I find it fascinating that AUD has appreciated over 25% since January and still remains somewhat undervalued as per PPP. I also enjoyed learning about the Big Mac Index. With calculator in hand, your example of this simple basis for valuation makes sense and is consistent with a "KISS" method, something I appreciate most dearly! Thanks for sharing this information and for your dedication to helping us learn these markets.

blinky

October 12, 2009 at 11:53 AM ET

What do risk appetite and risk aversion refer to specifically? With respect to currencies?

klien

October 12, 2009 at 11:55 AM ET

Risk Appetite = Desire to take on risk which is usually positive for equities and high yielding currencies but negative for the dollar

Risk Aversion = Lack of desire or aversion to take on risk which is usually negative for equities and high yielding currencies but positive for the dollar

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.