Tuesday, October 19, 2010

Currency Valuations as Suggested by Purchasing Power Parity

The concept of purchasing power parity (PPP) suggests that a country's exchange rate in relation to other countries' currency exchange valuations are in equilibrium when their actual purchasing power are the same in each of the two compared countries. Hence, the exchange rate between two countries in theory should equal the ratio of the two countries' price level for a fixed basket of products / goods & services.The Economist magazine (UK based) publishes a well known Burger Index comparing the price of a McDonald's Big Mac in various countries using the price of a United States made Big Mac as the base value. Recently, purchasing power parity has made some candid observations about currency valuations:

Switzerland's franc (CHF) is heavily overvalued in relation to the US dollar

The Chinese yuan renminbi is undervalued. If you happen to find yourself in China and hungry, a Chinese made Big Mac will be very affordable especially if you are traveling from Europe.

Currencies that appear to be significantly overvalued to the USD are Denmark, Norway, Sweden, Canada by upwards of 15 to 20% and Japan.

Undervalued currencies include Russia, many Asian countries such as the Philippines, South Korea, Hong Kong / China, Malaysia, etc. Surprisingly, countries like Poland, Mexico, Hungry and Turkey are other countries that PPP suggests that their currencies undervalued.

Commodity currencies such as Brazil, Australia, New Zealand, Canada appear to be headed for a correction. Our forecasts at BankIntroductions.com calls for a short term reversal in valuation for the USD as it has had a difficult three months with expected QE2 on the horizon this November 2010. In our view, it seems the market has already priced this in the USD currency valuation and the market may rally the USD on the actual day of event of quantitative easing round number two. It is the reverse to what logic suggests.

Sort of like buy on mystery, sell on the news!

The Euroland euro (EUR) at this time also looks a little frothy as they have significant economic challenges of their own including member countries Greece, Portugal and Spain experiencing economic headwinds. France is in the midst of labor revolt. This euro overvaluation is confirmed by PPP with a 20% overvaluation rating for EUR in relation to the USD.

Interesting times in the world of currencies. Our short term bet is to hold USD; gold bullion may have a correction of upwards of $200 USD an ounce over the next few months.

Happy speculating this Halloween season!