The U.S. Dollar: Building A Better Valuation Tool

February 8, 2012 9:00 am

Some believe that the U.S dollar is doomed. They believe that the U.S. is bankrupt and the best idea is to get all of their assets out of the U.S. and move them toward hard assets or The Bank of Mattress.

With all that Mr. Bernanke is doing with low rates and threats of another round of Quantitative Easing, the U.S. dollar has been under pressure. Naturally, currencies are traded in crosses, so the valuation on that basis depends on currency against another.

So, when looking at the value of the U.S. Dollar against the Yen or Euro, one can come to the conclusion that there is a devaluation occuring. But to get a better picture of the actual value and compare to a longer time frame, the better indicator is the BOE Calculated Exchange Rate.

Definition

An effective exchange rate is a measure of the value of a currency against a `basket’ of other currencies, relative to a base date. It is calculated as a weighted geometric average of the exchange rates, expressed in the form of an index. The effective exchange rate indices for sterling and other currencies published by the Bank are based on the method the IMF uses to calculate effective exchange rates for a number of industrialized countries.

The weights used are designed to measure, for an individual country, the relative importance of each of the other countries as a competitor to its manufacturing sector. The trade weights reflect aggregated trade flows in manufactured goods for the period 1989 to 1991 and cover 21 countries. The base date for the index is 1990, and is set at 100.

Using this tool, we can better ascertain the value of a currency inclusive of a country’s output potential. Think of it as a PEG ratio of sorts.

In the case of stocks, a LOW PEG is a desirous condition as it shows that investors may not be paying enough for a company’s future earning potential.

From this chart, we can see that the U.S. dollar is under the 10-year moving average and riding the 20% undervalued trend. If this was a stock, some would say that it is a bargain at this price.

Since 1987, there have only been 2 instances that the 20%-undervalued line has been breached. Yes, at this point the trend is down and the monthly averages are all trending lower as well. Obviously this is not what we want to see. However, if economic reports continue to surprise to the upside, there is a good chance that the bounce occurring will continue.

With all of the speculation on the short side of this trade, there is a great opportunity to see a short squeeze in the near future…Keep a close watch.

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