Today's comment is by Kathy Lien and Boris Schlossberg, award-winning Forex traders and editors of The Sovereign Society's currency trading service, The Money Trader.
Dear A-Letter Reader:
No doubt you've heard of economics and probably even Freakonomics, but have you ever heard of burgernomics? Some of you are probably nodding your heads as the Big Mac "burgernomics" index celebrates its 20th anniversary.
Two decades ago, the editor of the world renowned magazine, The Economist had the ingenious idea of launching a Big Mac index to teach the world about currency valuations. As a testament to its success, the index is taught in colleges around the world to this day.
The idea behind The Economist's Big Mac Index is a light hearted but fundamentally logical attempt to demonstrate the idea of Purchasing Power Parity (PPP). Purchasing Power Parity is the theory that the same basket of goods should have equal value regardless of the currency a consumer uses to purchase those goods.
In Burgernomics, McDonald's Big Mac represents the "basket of goods." It's perfectly logical to use burgers as the barometer because the exact same McDonald's Big Macs are available all over the world. It should come as no surprise that the burger patties you've snacked on since childhood are frozen and imported rather than being freshly homemade in your local McDonalds. Otherwise, it probably would not be known as fast food.
If you walk into a McDonald's in New York and one in Beijing, the Big Mac that you order will be identical. However, if their prices are different, then a country's currency is assumed to be under or overvalued. The Big Mac index is far from perfect since it fails to account for things like local taxes, cost of real estate and import duties for burgers.
Of course, "burgernomics" was not meant to be an exact science and give precise indications of the correct global exchange rates, but instead merely a fun guide to long term trends. Surprisingly, over the past two decades, the Big Mac Index has been uncannily correct at uncovering over and under-valuations despite some of its shortcomings.
Recently, the Big Mac index has been used to prove whether the Chinese Yuan is being manipulated and purposely kept undervalued. According to the index, a Big Mac in China costs Yuan 10.50, which is equivalent to $1.31. The same burger in the United States costs $3.10. When you divide the "correct" price in the U.S. by the Chinese price, the implied value of the dollar is $3.39. However the actual exchange rate of the Yuan is currently $8.09. According to the PPP theory, this makes the Yuan undervalued by 58 percent against the dollar! (And it also makes China the cheapest place to get a Big Mac in the world.)
The most expensive places in the world to buy a Big Mac are Iceland and Norway, where the exchange rate is extremely overvalued. If you pull up to a McDonald's drive-thru in Iceland, they'll charge you US $6.37 for your Big Mac. In Norway, they'll charge you US$7.05 for a "Norwegian" Big Mac. In both instances, the Big Mac Index tells us that the dollar is undervalued against those currencies.
We're always thinking about how we can exploit this "burgernomic" knowledge. Recently, every analyst on CNBC has been warning about the demise of the dollar. These analysts argue high energy prices, the huge trade deficit and a bursting housing bubble could all force the Federal Reserve to forgo another interest rate hike later this month. When the Fed stops raising rates, their attempt to increase the yield will also end. And so ends the attractiveness of the U.S. dollar.
So if we know that the dollar is headed lower, what is the best currency to sell it against? If we relied solely on the Big Mac Index, the best play would be perhaps the Japanese Yen. In Japan, a Big Mac costs 250 Yen or US $2.23 instead of $3.10 in the U.S. This suggests the Japanese Yen is 28 percent undervalued and the US dollar overvalued against it.
However we caution you that relying on the Big Mac Index alone to pick trades. The valuations do correct themselves, but it can take decades. Within that time there can be significant fluctuations.
And as we have said, the Big Mac Index is far from perfect. The cost of real estate and labor in each country is different. Also, competition is important. In the U.S., a Big Mac is considered a cheap fast meal, while in a country like Malaysia a Big Mac is considered a luxury. Therefore, in evaluating this index we need to account for difference in demand preferences as well.
Although "burgernomics" is a fun and interesting way to learn the basics of how currencies should be valued, there are many other factors that can impact a currency's valuation. Still for sheer simplicity and surprising effectiveness, we're lovin' the Big Mac Index.
KATHY LIEN & BORIS SCHLOSSBERG
Editors of The Money Trader on behalf of
The Sovereign Society
http://www.money-trader.com/
EDITOR'S NOTE: Next week, Boris and Kathy will take you beyond "burgernomics" into the largest financial market in the world: the $1.9 trillion spot currency market. In a series of articles, they'll show you exactly how the market works, how to open a currency trading account for as little as $500, how to trade conservatively with little or no leverage, or aggressively but smart, targeting triple-digit profits while strictly limiting risk. In short, they'll show you how you can protect yourself and profit from the dollar's windfall... beyond scooping up under-priced Big Macs in Beijing.