Euro is the most undervalued G10 currency
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Foreign Exchange

Euro is the most undervalued G10 currency

The euro is the most undervalued G10 currency on a purchasing power parity (PPP) basis, according to Morgan Stanley.

The bank’s model also shows that the Australian and New Zealand dollars are the most overvalued currencies. The shortcomings of PPP models, which are based on the theory that over the long run exchange rates are reflections of price differentials between countries, are well known.

Although simple and elegant, PPP models ignore the fact that not all goods and services are tradeable, and also do not take into account tariffs and transaction costs, which can distort arbitrage opportunities between countries.

Furthermore, as Dara Blume at Morgan Stanley points out, it is unclear how long it takes for the exchange rate to mean-revert back to the fair-value PPP level, so adjustment could be a longer-term process.

“Despite these drawbacks, PPP does provide a useful baseline for evaluating where a currency should be trading based purely on pricing fundamentals,” she says.

“Considering why currencies deviate from PPP fair value sheds light on the major market factors driving a given currency at that moment.”

 G10 FX misalignments on a PPP basis

 Source: Morgan Stanley

Blume notes that while the EUR is the most undervalued currency, sovereign risk, which has obviously undermined the currency, is not incorporated in the PPP framework.

“We believe that fiscal and monetary factors not captured in the PPP model will continue to drive EUR, and remain bearish,” she says.

“Similarly, CHF is overvalued on a PPP basis, but given that CHF is likely to strengthen on the back of European sovereign concerns due to safe-haven flows from the euro area into Switzerland, we remain bullish on CHF, at least against EUR.”

Meanwhile, AUD and NZD are the most overvalued currencies, which is partly explained by the fact that PPP models are not good at capturing swings in the terms of trade, which have risen to record highs in Australia and New Zealand.

Morgan Stanley expects the terms of trade for both the AUD and NZD to fall over the coming months. “Both currencies also remain vulnerable to falling global growth, and we recommend selling both currencies, as suggested by the model,” says Blume.

The remaining G10 currencies, except NOK, which is likely to be undervalued because of high oil prices, are roughly in line with PPP-implied fair value.

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