Recently, U.S. investment bank Goldman Sachs changed its short-term and long-term forecasts on the euro versus the U.S. dollar. In its report, the firm calculated a current fair value of the EUR/USD at 1.19. That is considerably less than the current exchange rate of EUR/USD 1.31.
Currency markets are fast paced and incredibly complex. On the top level there are only two determinants that impact the appreciation or depreciation of a currency: supply and demand. However, there are a myriad of factors that can impact each side in balancing these two factors.
As demonstrated recently with the turmoil in the Ukraine, there was tremendous pressure on the currency markets by investors who were quickly selling the currency as the longer-term stability of the nation started to be in question. This supply of currency caused a precipitous drop in value versus the U.S. dollar from the beginning of January to mid-March, to the tune of a -36.6 percent depreciation.
Likewise, on the demand side, as the global economy started to pick up from the lows of 2009, investors and institutions started to increase their purchase of commodities such as gold and iron ore. This in turn greatly increased the value of currencies of nations that are large commodities producers, one of which is Australia. It saw a 27.55 percent increase in its currency value from March 2009 to September 2009.
Both of these moves seem very extreme and raise a question: With the exception of extraordinary events, is there generally a limit to how much foreign exchange should move? The answer is “yes.” Barring an extraordinary event, currency usually will trade within a reasonable range around its fair value.
What is a currency’s fair value and how do analysts come up with it?
When valuing a currency, one of the most basic measurements is purchasing power parity (PPP). Purchasing power parity takes a basket of goods in one country and that same basket of goods in another country, and the premise is that the baskets of goods should cost a similar amount given the current currency exchange. When the two exchange rates are equal, you would assume that they are in equilibrium, or around its fair value.
Another version of this barometer of fair value that has gained popularity over the years is called the “Big Mac Index,” which was developed by the Economist in 1986. The thought was that the exact same ingredients go into a Big Mac in every location, which now spans more than 120 nations.
Therefore, there should not be a substantial difference in the price of a Big Mac among the locations. If the sandwich seems ridiculously expensive in one location, then you would consider that currency overvalued, and if you thought it was incredibly cheap, then the currency could be considered undervalued. Over the long term, the currency should move toward its fair value.
This is a very good model, but as with all models, they can be somewhat simple and not take in all the factors. For example, the index doesn’t take into consideration things such as certain locations are just more expensive. To run a McDonalds in New York City will be significantly more expensive than in Bali, Indonesia. Therefore, the price of the sandwiches should be different.
What can impact foreign exchange rates going forward?
One thing that can greatly impact the outlook of future exchange rates is expectation. In the case of the weakening of the euro to the U.S. dollar, the investment bank cited a “fundamental change” in the Euro-Area as the main contributing reason. More specifically, the bank felt the continued easing of the European Central Bank will encourage the search for higher yields.
The is due to the unprecedented monetary stimulus which has been global in scope in this post-crisis cycle. It is the divergence of the European Central Bank from the rest of the central banks in the developed world that is now causing the fundamental change.
In August, both the two-year and three-year German government bond dropped below a zero yield. Negative short-term rates have been mandated by the ECB since mid-June, but it has taken time for markets to absorb the view that the Eurozone economy and the ECB are collectively in a bit of trouble given the deflationary environment.
By contrast, three-year U.S. Treasury rates were approximately 1 percent, and U.K. gilts were a relatively spectacular 1.25 percent. Interest rate differentials like this may result in a change in the relative value of the currency of the lower-yielding country. That is exactly what we saw in 2013, with the euro depreciating by more than 4 percent versus both the dollar and pound sterling.
Forecasts are for both the Bank of England and the U.S. Federal Reserve to increase interest rates sometime in 2015. The ECB, for its part, will be trying to decide whether additional stimulus and even deeper negative rates are needed to right the ship.
Therefore, there is a high probability that the euro could continue to languish versus sterling and the dollar in 2014, and particularly as rate increases come closer to fair value in 2015. At the end of August, the large U.S. investment bank mentioned previously lowered its euro vs. USD forecast to EUR/USD 1.15 for the end of 2015 and parity (1:1) by 2017.
As an investor, it may be an area worth paying close attention to over the next few years.
Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.