Global Strategy Note: Week of July 23, 2017
Currencies sometimes seem to defy analysis and take on a life of their own. Intrinsically they should be relatively simple constructs that remove the possibility of arbitrage. That is the principle of price Purchasing Power Parity (PPP). Essentially, a commodity should cost the same the world over once allowing for tax and cost differences and currencies should adjust to make that so. Inside we use these simple principles to determine the “fair value” of an exchange rate.
Our fair value for the Canadian dollar (CAD) is 1.35 versus the US dollar (USD) which means it is currently 8% over valued and due for a correction. Indeed, given the speed of the recent appreciation in the Loonie, the currency is also three standard deviations “overbought” on our momentum analysis (Figure 1) which also suggests an imminent correction. The last time the currency was this far overbought was in 2011 and it had corrected to oversold within six months. The Loonie has flown too far too fast – mind your eye!
Figure 1: CAD 3 standard deviations overbought
It is tempting to value the CAD using commodity prices, observing the strong correlation between the two. As we show in Figure 2 and 3 below, the stronger the oil (or copper) price, the higher the value of CAD. In both figures we have reversed the scale on the commodity axis. These relationships would seem to suggest that the CAD is about fair value, and to make further gains against the USD, the oil and or copper price would need to rise further. We have long argued that the oil price is likely to end the year at around $50 and therefore would not expect significant further CAD strength on the basis of this analysis. That said, these relationships are rather imprecise and it is difficult to infer an accurate fair value from these charts - we can do much better.
Figure 2: CAD versus USD and the oil price in USD
Figure 3: CAD versus USD and the copper price in USD
Using the principle of Price Purchasing Power Parity (PPP) we can estimate a “fair value” for a currency. That is, the price of a commodity or a well specified good should be the same in all countries once allowing for tax and cost differences. For example, in Figure 4 we compare prices of iPads, cars and hand bags in both CAD and USD and calculate the PPP exchange rate that results. In this case, the PPP exchange rate is calculated from a small sample of items, with Louis Vuitton providing the best “fit” in terms of the current exchange rate.
Figure 4: CAD versus USD and the copper price in USD
Using a larger and more representative basket of goods will provide a more accurate PPP exchange rate. Essentially that is what we have done in arriving at our fair value estimate of the CAD in Figure 5. Our augmented PPP model uses not just relative prices, but relative interest rates, and productivity differentials too. Indeed we use eight separate factors and estimate them over 42 different exchange rates since 1980 controlling for both time and country. This longitudinal approach yields interesting results, including the fair value of the CAD which we estimate to be 1.35 (8% below where it is currently trading). While that represents an appreciation in fair value since last year, it is in no way consistent with the sharp rise in CAD strength seen over the past few weeks and signals a likely correction.
Figure 5: CAD versus USD and fair value
Applying this same approach to other major currencies provides some similarly interesting results. When we apply a Brexit control for Sterling, we find that our estimate of fundamental fair value falls from 1.45 to 1.30 against the USD, roughly where it is trading now (Figure 6). We also estimate that the Euro is about right priced at 1.18 against the USD but the Yen should be trading at 100 versus the USD (Figure 7). While the USD has softened considerably this year, our analysis would suggest that it is not too weak against all currencies – notably the Euro and Sterling.
Figure 6: Sterling versus USD and fair value
Figure 7: Yen versus USD and fair value
Global Strategy Team:
Senior Research Analyst
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