Do Currencies Have a Fair Value?

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1 Do Currencies Have a Fair Value? May 2011 George Saravelos European FX Strategist IMPORTANT: PLEASE SEE CONFLICT DISCLOSURES AND ANALYST CERTIFICATION IMMEDIATELY AT THE END OF THE TEXT OF THIS REPORT. DEUTSCHE BANK DOES AND SEEKS TO DO BUSINESS WITH ISSUERS COVERED IN ITS REPORTS. AS A RESULT INVESTORS SHOULD BE AWARE THAT DEUTSCHE BANK MAY HAVE A CONFLICT OF INTEREST THAT COULD ADVERSELY AFFECT THE OBJECTIVITY OF ITS REPORTS. INVESTORS SHOULD CONSIDER THIS REPORT ONLY AS A SINGLE FACTOR IN MAKING THEIR INVESTMENT DECISION.

2 March What is fair value?

3 The Simplest Answer Fair value P* is the price that equates supply and demand An asset always trades at fair value! (Otherwise known as the efficient market hypothesis) P* March

4 What Are the Slopes of the Curves? In a perfectly rational, profit-maximizing and efficient world, the demand curve is horizontal The market always trades at P*. If P < P* demand is infinite; if P > P* demand drops to zero P* shifts as fundamentals shift In practice, the efficient markets hypothesis does not hold, so prices can deviate from P* P* March

5 More Importantly, What is the Fair Price P*? For equities, it is the net discounted cash flow of future earnings For bonds, it is the net discounted cash flow of future interest payments + principal For currencies? There is no universally agreed model of fair value! March

6 But Is a Fair-Value Measure in FX So Elusive? Short-term, we don t really have a model for P* Ultimately an exchange rate reflects the relative price of goods and assets between two economies Short-term, frictions mean the relative value of tradable goods/assets can deviate between countries But long-term, deviations from fair value cannot persist, otherwise known as Purchasing Power Parity (PPP) theory PPP is one of the most widely supported theories in empirical finance We might not know what P* in currencies is but we know when the deviations from P* become large! March

7 6 Evidence (I) GBP has maintained its real value for over 200 years, floating within a 40% valuation band of % 6% 4% 2% GBP / USD (rhs) U.S. Civil War US CPI - UK RPI (10y ma, lhs) Real GBP / USD (rhs) UK defends gold peg 1976 crisis % -2% 4-4% 3-6% UK capitulation 2-8% Source: Deutsche Bank calculations, using data from Lawrence H. Officer, Dollar-Pound Exchange Rate from 1791, The Annual Consumer Price Index for the United States , What Were UK Earnings and Prices Then, Measuring Worth, Note: proxies of US CPI, UK RPI back to 1790, real /USD = 1.65 in March

8 7 Evidence (II) Gold holds value during currency debasement; gold is co-integrated with UK RPI since 1260! GBP/SEK rises with PPP fair value in Russian War; real depreciation during gold standard 15% 10% 5% 0% Inflation (YoY, 20y ma, lhs) Gold (2009, rhs) UK RPI (2009 = Gold in, rhs) Edw ard VI debases World War I Napoleonic -5% Wars GBPSEK PPP (lhs, 1950 = 100) GBPSEK ER (rhs) Gold standard 5 50 Napoleonic, Russian Wars Source: Deutsche Bank, Lawrence H. Officer, The Price of Gold, , Measuring Worth, Source: Deutsche Bank, Riksbank, Measuring Worth. Note: Grey line is nominal GBP/SEK, Black line is real GBP/SEk. Riksdalers used for krona prior to Military expenditure in the period was likely spent on both the Russian War and Napoleonic War. March

9 8 How to Measure It? (I) Absolute PPP How Much Stronger Should Currencies Be To Equate the Value of the Big Mac in the US versus 120% 100% 80% IMF OECD Big Mac 60% 40% 20% 0% NOK CHF SEK AUD JPY CAD NZD EUR GBP Source: OECD, EcoWin, Bloomberg Finance LP, Economist, Deutsche Bank estimations and calculations. Note: OECD and Economist data from Bloomberg (PPP <GO>), Implied PPP Conversion Rate used for IMF fair value. Other sources of PPP data include the World Bank WDI and Penn World Tables. March

10 How To Measure It? (II) Relative PPP Assume a base period (ie period during which exchange rate was close to P*) Adjust for relative changes in CPI (or PPI, or Unit Labor Costs) 80% 70% Bloomberg Relative PPP Average of Absolute PPP Measures 60% 50% 40% 30% 20% 10% 0% NOK NZD AUD CHF EUR JPY SEK CAD GBP March

11 Delving into PPP More Deeply (I) Geography matters countries with closer trade links see smaller deviations from PPP Example: Switzerland and Europe EUR/CHF Has Pretty Small Deviations from PPP Big Reliance on Trade with Eurozone 250 Gross trade flows (lhs, bn CHF) Net trade flows (rhs, bn CHF) Eurozone US East. Eur Devel. Eur Rest of G10 EM -5 March

12 Delving into PPP More Deeply (II) Exchange rate regime matters: adjustment can take place through the domestic price level rather than the exchange rate is FX is fixed USD against EM currencies adjusted for price changes USD against EM currencies March

13 KRW INR HKD TWD MYR CNY VND PHP THB SGD IDR Deutsche Bank s Latest Measure of PPP Developed World: USD Cheap Asia FX: USD (Mostly) Expensive 30% 20% 10% 0% -10% -20% -30% -40% -50% -60% Standard PPP estimate PPP adjusted for prdctvty Average overvalued undervalued March

14 Going A Bit More High-Frequency Interest rates, commodities can influence P* in short to medium-term A behavioral effective exchange rate model (BEER) adjust PPP for these BEER Model Results Coefficients Valuation Diagnostics TOT 3M Rates Model PPP R 2 Half-life (yr) Cointegration? JPY % -5.23% 61% 1.3 YES NZD % 4.51% 9% 2.3 NO CAD % 17.32% 40% 4.7 NO CHF % 18.55% 41% 1.5 YES NOK % 13.58% 59% 0.9 YES EUR % 1.08% 9% 1.9 NO AUD % 19.16% 17% 2.9 NO SEK % % 15% 1.8 NO GBP % % 34% 1.8 YES USD % % 63% 1.6 YES Panel Cointegration? Panel Unit Root Tests REER TOT 3M RATES YES BORERLINE UNIT ROOT STATIONARY March

15 So Which Currencies Are Most Expensive? Spot Relative to Its PPP Valuation Bounds PPP But Adjusted for Terms of Trade/Rates % Over-valuation Relative to PPP % Band Within Which 90% of Observations Lie, AUD NZD CHF CAD EUR JPY GBP Ranking of BEER 10 Valuation SEK JPY GBP EUR NOK CAD CHF NZD AUD Ranking of PPP valuation March

16 Is It Possible to Make Money? A Trading Strategy Based on Absolute PPP A Trading Strategy Based on Relative PPP 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% Valuation March

17 Conclusions Though establishing fair value for a currency is more difficult than other asset classes, it is easier to identify extreme deviations in FX. The assumptions that go into measuring PPP are often less than those required to value stocks or bonds. For long-term value investors, currencies are one of the most attractive asset classes. There is solid academic evidence in favor of mean-reversion to PPP. Geography influences how far valuation extremes can go. Cyclical drivers such as interest rates and commodities are also important. The USD is particularly cheap versus CAD, CHF and NZD. Its still expensive versus Asia FX. March

18 CERTIFICATION The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. For disclosures of our potential conflicts pertaining to analyses, recommendations or estimates made in respect of a security or issuer mentioned in this report, please see the most recently published issuer report or visit our global disclosure look-up page on our website at DISCLAIMER The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively Deutsche Bank ). The information herein is believed by Deutsche Bank to be reliable and has been obtained from public sources believed to be reliable. With the exception of information about Deutsche Bank, Deutsche Bank makes no representation as to the accuracy or completeness of such information. This published research report may be considered by Deutsche Bank when Deutsche Bank is deciding to buy or sell proprietary positions in the securities mentioned in this report. For select companies, Deutsche Bank equity research analysts may identify shorter-term opportunities that are consistent or inconsistent with Deutsche Bank's existing, longer-term Buy or Sell recommendations. This information is made available on the SOLAR stock list, which can be found at Deutsche Bank may trade for its own account as a result of the short term trading suggestions of analysts and may also engage in securities transactions in a manner inconsistent with this research report and with respect to securities covered by this report, will sell to or buy from customers on a principal basis. Disclosures of conflicts of interest, if any, are discussed at the end of the text of this report or on the Deutsche Bank website at Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate, except if research on the subject company is withdrawn. Prices and availability of financial instruments also are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as an offer to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction. The financial instruments discussed in this report may not be suitable for all investors and investors must make their own investment decisions using their own independent advisors as they believe necessary and based upon their specific financial situations and investment objectives. If a financial instrument is denominated in a currency other than an investor s currency, a change in exchange rates may adversely affect the price or value of, or the income derived from, the financial instrument, and such investor effectively assumes currency risk. In addition, income from an investment may fluctuate and the price or value of financial instruments described in this report, either directly or indirectly, may rise or fall. Furthermore, past performance is not necessarily indicative of future results. Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor s home jurisdiction. In the U.S. this report is approved and/or distributed by Deutsche Bank Securities Inc., a member of the NYSE, the NASD, NFA and SIPC. In Germany this report is approved and/or communicated by Deutsche Bank AG Frankfurt authorised by Bundesanstalt für Finanzdienstleistungsaufsicht. In the United Kingdom this report is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange and regulated by the Financial Services Authority for the conduct of investment business in the UK and authorised by Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin). This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. and in Singapore by Deutsche Bank AG, Singapore Branch. In Japan this report is approved and/or distributed by Deutsche Securities Inc. The information contained in this report does not constitute the provision of investment advice. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. This report may not be reproduced, distributed or published by any person for any purpose without Deutsche Bank's prior written consent. Please cite source when quoting. Copyright 2009 Deutsche Bank AG March

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