Posts Tagged ‘PPA’

The more it changes, the more it is the same

Saturday, November 5th, 2011

The euro exchange rate is probably the most important FX number to follow. The Yen is not as prominent as it used to be given the relative decline of the Japanese economy. The Reminbi will certainly become the leading currency but we are not there yet. The British Pound, Swiss Franc or Australian dollar are indeed interesting pieces of the FX puzzle but with a more local flavor. By default this leaves the EUR has the main currency to monitor (unless you think Gold is a currency).

And it is amazing how stable the euro has been in the past few years. If you have a look at the chart of the past five years of data, it is clear that we have a range [1.20-1.60] with an attraction value of 1.40. You can run all statistical tests you wish, but here the eye ball analysis tells a clear story of a mean reverting asset, with a mean around 1.40. The market tested 1.60 in a double top formation, but failed and collapsed steeply from there. A few years later it was time to attempt 1.20 and here again the V-shaped reversal was swift.

The chart shows an oscillation around 1.40 and it seems that for once the PPA is working. PPA in other words parity of purchasing power is a fundamental theory for valuing currencies. It simply says that physical assets, and in particular consumption goods, should have about the same value in various currencies otherwise arbitrage opportunities will arise that will bring back the forex level to a more realistic level. Of course this theory is just a framework for thoughts as currencies have a tendency to derail from it. To take 2 examples from the currencies previously mentioned, the Yuan has beem undervalued for a few decades (based on PPA), while Swiss products and cost of living remain consistently pricey.

The PPA is better illustrated by following ‘The Economist’s Mac Donald Index’ which compiles the value of a Big Mac all over the world. Back to the euro, Western Europe and the USA have many similarities, both are large, stable and developed economies with a lot of commerce and exchange between the two. So when the euro reached 1.60, it seemed like Europeans became undeservingly rich compared to Americans and anyone could fly to New York and have the time of their life. Conversely at 1.20 it was Americans who found themselves with a bargain.

These economies are similar with respect to their modest growth and to their large middle class and retired population. Europeans like to buy retirement homes in Spain or Marocco, but it the euro got too strong their may opt for a nice beach property in Florida. Likewise Americans would love to have a house in Europe if they can afford it. This type of supply demand equilibrium is part of what keeps the euro in check.

The above description was somehow the rosy scenario. Of course this assumes that the euro can survive its internal tensions, after all it is not a real currency issued by a sovereign state, so there is always the risk that it collapses. So far the Greeks have not yet killed the euro, but the battle is not over.

The stronger dollar

Friday, May 21st, 2010

My last post was titled “the strong dollar”, and there is no better title than “the stronger dollar” for this post. As the dollar has kept on getting stronger in the past few weeks.

After many years watching markets, the only fundamental truth that summarizes how markets move goes as follows: currencies are mean reverting and the extraneous shocks necessary to bring values closer to parity will occur. In other words when a currency is too pricey like the euro used to be, something will happen to make it cheaper like the current Hellenistic crisis.

And what is the best way to assess if a currency is too pricey beyond all sophisticated models created by erudite Doctors in Economics. Simply ask tourists who visit Europe from the USA or vice versa, and they will tell you when the God of Currencies has lost its mind, like when he had the euro at or over 1.50 to the dollar for a long period of time. This was so absurd that Paris was determined to be the most expensive city in the world for the cost of living according to a prominent European magazine.

Yes Paris was ahead of New York, Tokyo or Hong Kong. And given the relative wealth available in the 4 cities in question, this was simply a ludicrous bogus statistic stemming from an exaggerated value of the euro. Now back to a 1.25 FX rate, I bet you Paris is not number one anymore.

So often the highly complex econometric models from Ivy League educated Professors of Economics will equate with what all the talkative taxi drivers of the big cities in the world know from talking to travelers. Assuming such models are correct.

If there is a positive consequence from the Greek debacle, it is to bring the value of European assets back to more a reasonable level, starting with its currency the euro. The purchasing-power parity is what rules currencies at the end of the day and this is getting truer if economic players are given the opportunity to arbitrage geographical locations.

One such PPA model by the OECD said 6 months ago that the euro was 21% overvalued. Nice evaluation and it is now approximately correctly valued versus the green back. Another similar model by the IMF says that the Chinese Yuan is 75% undervalued and we all know this one. This is the reason why China is getting so strong with its cheap exports. And the Greek crisis is given them a new reason not to let their currency appreciate at this point.

USA: 0; Europe: -1; China: +1.

The strong dollar

Friday, February 26th, 2010

It is interesting to see how the FOREX market moves in waves and trends.

Not that long ago everyone was talking and blogging about the weak dollar, the end of America’s economic hegemony and its unsolvable deficit, deflation and the search for a replacement to the greenback.

Just a few months later the dollar has appreciated by 10% and the same bloggers are starting to worry if this dollar strength will have dire consequences. Here this discussion is focused on the USD versus Euro rate, a good summary of dollar strength or weakness.

This is all a matter of perspective. In my mind the EUR fluctuates in a big range [1.20-155] and this is where it belongs. Parity of purchasing power is a concept that traders and short-term investors tend to forget, but this is truly what defines the exchange rate. There are arbitrages from real good markets that guarantee that the dollar cannot stay too strong against the euro forĀ  a prolonged period of time, and vice versa.

This fundamental truth is getting truer and truer and this is what guarantees that PPA theory will have its moment of glory. This is truer because the world is more integrated and arbitrages in real goods are easier and more predominant.

For example retired people in Europe may decide to buy their second home in Spain or in Florida. In the upper middle class this is common and the level of the exchange rate will be a significant determinant in their choice. As flying is easy and cheap, it does not make much difference to fly from Budapest to Barcelona or Miami.

The Internet facilitates the buying of all kinds of products that will be manufactured on the continent with the more favorable exchange rate. If one of the currencies were to diverge too much, natural commerce adjustments will occur that will modify supply demand to reverse the imbalance and the trend.

America and Europe are getting more alike, culturally and commercially, hence their currencies will stay in line for the most part. So expect the EUR to stay within [1.20-1.55] in the foreseeable future. But of course play the small trends and swings for short-term trading profits.