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.
March 2011 1 What is fair value?
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 2011 2
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 2011 3
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 2011 4
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 2011 5
6 Evidence (I) GBP has maintained its real value for over 200 years, floating within a 40% valuation band of 1.60 8% 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 8 7 6 5 0% -2% 4-4% 3-6% UK capitulation 2-8% 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 1 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 1774-2008, What Were UK Earnings and Prices Then, Measuring Worth, 2009. Note: proxies of US CPI, UK RPI back to 1790, real /USD = 1.65 in 2009. March 2011 6
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 1 1260 1335 1410 1485 1560 1635 1710 1785 1860 1935 2010 1000 100 10 350 300 250 200 150 100 GBPSEK PPP (lhs, 1950 = 100) GBPSEK ER (rhs) Gold standard 5 50 Napoleonic, Russian Wars 0 0 1659 1709 1759 1809 1859 1909 1959 2009 25 20 15 10 Source: Deutsche Bank, Lawrence H. Officer, The Price of Gold, 1257-2008, Measuring Worth, 2009. 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 1804. Military expenditure in the 1785-1810 period was likely spent on both the Russian War and Napoleonic War. March 2011 7
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 2011 8
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 2011 9
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) 200 150 100 50 0 25 20 15 10 5 0-50 Eurozone US East. Eur Devel. Eur Rest of G10 EM -5 March 2011 10
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 150 140 130 120 110 100 90 80 USD against EM currencies adjusted for price changes USD against EM currencies 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 March 2011 11
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 2011 12
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 1.011 0.581 18.7% -5.23% 61% 1.3 YES NZD -0.070 0.944 11.2% 4.51% 9% 2.3 NO CAD 1.135 1.220 10.5% 17.32% 40% 4.7 NO CHF 1.891 0.639 8.2% 18.55% 41% 1.5 YES NOK 0.184 0.423 4.4% 13.58% 59% 0.9 YES EUR 0.144 0.798 2.6% 1.08% 9% 1.9 NO AUD 0.182 2.044-0.7% 19.16% 17% 2.9 NO SEK 0.159 1.854-7.8% -11.26% 15% 1.8 NO GBP 2.018 2.117-10.9% -14.24% 34% 1.8 YES USD 2.667 0.347-14.0% -27.19% 63% 1.6 YES Panel Cointegration? Panel Unit Root Tests REER TOT 3M RATES YES BORERLINE UNIT ROOT STATIONARY March 2011 13
So Which Currencies Are Most Expensive? Spot Relative to Its PPP Valuation Bounds PPP But Adjusted for Terms of Trade/Rates 35 30 25 20 15 10 5 0 % Over-valuation Relative to PPP % Band Within Which 90% of Observations Lie, 1976-35 30 25 20 15 10 5 0 AUD NZD CHF CAD EUR JPY GBP Ranking of BEER 10 Valuation 9 8 7 6 5 4 3 2 1 0 SEK JPY GBP EUR NOK CAD CHF NZD AUD 0 2 4 6 8 10 Ranking of PPP valuation March 2011 14
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 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 March 2011 15
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 2011 16
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