The US dollar is currently the most overvalued currency in the world.
That’s the assessment of Deutsche Bank’s newly-introduced capital-based valuation model which suggests the greenback is currently the most expensive currency in the world, beating out the South Korean won and Chinese yuan for top spot in its latest rankings.
At the other end of the spectrum, the model suggests that emerging market currencies such as the Turkish lira, Colombian peso and Mexican peso are the most undervalued currencies in late 2017.
This chart from Deutsche Bank shows the current rankings.
Based off capital and trade-based valuations, the further out from the centre the black line sits, the cheaper a currency is deemed to be.
“Capital flows have gained in importance over the past three decades and now account for the lion’s share of cross-border transactions. Yet, all the established fundamental FX valuation approaches are based on trade, not capital flows,” says Deutsche.
In an attempt to better identify which currencies are overvalued or undervalued based on capital flows, Deutsche created its capital-based valuation model (Cap-PPP), something it says draws strong parallels with traditional trade-based PPP [purchasing power parity] modelling.
“PPP involves deflating nominal trade-weighted indices by goods prices to obtain real effective exchange rates (REERs),” it says.
“Cap-PPP involves deflating nominal capital-weighted indices by bond and equity prices to obtain real effective financial exchange rates (REFERs), then comparing REFERs to historical averages.”
According to Deutsche, it found strong evidence that its Cap-PPP model has significant predictive power for FX, both in terms of directional accuracy and the magnitude of moves, especially over longer-term horizons.
In order to come up with a currency valuation based on fundamentals, Deutsche has combined its trade and capital flow models to provide a better picture on what’s expensive and what’s cheap based on both metrics.
“A more complete picture of valuations is hence obtained by combining both models, which we do to produce an ‘overall’ weighted valuation, using weights that reflect the relative importance of capital and trade flows for each currency,” it says.
And given the models current assessment, the US dollar is looking expensive, something that will undoubtedly have ramifications for global asset markets should it weaken in the period ahead.