Perhaps the euro and british pound’s comeuppance vs. the dollar was well overdue. Calafia Beach Pundit (CBP) explains how the reversal and weakening of both currencies against the dollar actually fits the notion that currencies should hug their relative value based on ‘purchasing power parity’ (PPP) over the long-term. (PPP is based on ‘the idea that in absence of transaction costs, identical goods will have the same price in different markets.‘)
We love to trash economic theory, but admit that much of it is valid over the long-term. (if not the short-term). PPP at its core makes sense after all.
On this note, CBP shows how the euro is now merely approaching fair value vs. the dollar based on PPP, it has ways to go before being deeply undervalued based on this metric.
The British pound is in a similar boat, you can find CBP’s chart here.
So the EUR/USD appears to have eventually fallen in line with PPP. This makes us wonder what’s coming next for the Australian dollar:
CBP highlights that the Canadian dollar and Brazilian real have similar looking charts to the AUD/USD chart above.
But they do seem to be pushing their limits. When a currency is stretched relative to its PPP, the news has to continue to be awfully good (or awfully bad, as the case may be), in order to sustain those valuation extremes. So that means AUD and CAD are very vulnerable to any signs of a) weaker growth, b) tighter monetary policy in the developed world, or c) weaker commodity prices. Being long these currencies at these levels requires courageous conviction.
This doesn’t mean their currency values are necessarily ‘bad deals’, but rather that they are similar to stocks with high price-to-earnings ratios — they require substantial and continued good news just to maintain their current valuation level.
Thing is, given risk of a China slow-down hitting Australian commodities demand, risk of Australia’s new super profits tax stifling its mining industry, signs of economic duress among Australians themselves, and now CBP’s chart above, going long the Aussie dollar seems tenuous. A crashing AUD/USD seems like the path of least resistance going forward.