With tax cuts and tax returns on everyone’s minds, we think it is a good time to look closely at our favorite currency! We might call it “dough”, “bread” or “cheddar”, we have “bean”-counters to keep track of it and we use simple, gastronomic valuations, like the Big Mac Index, to compare it to its peers. Thinking about the US dollar and its’ value might just make you hungry! The dollars’ worth is determined by the foreign exchange market, but investors and economists alike are always looking for ways to value the currencies and look for explanations or even monetary conspiracies, to explain currency fluctuations.
In 1986, The Economist came out with the Big Mac Index as a simple way to discuss exchange rates and purchasing-power parity (PPP), which compares the amount of currency needed to buy the same item in different countries, in this case a Big Mac. The Wall Street Journal came up with their own modernized version of this same idea with their Latte Index, which compares the price of a Starbucks tall latte in cities around the world. For example, in New York City, the WSJ reporter could buy a tall latte at Starbucks for $3.45. Other WSJ reporters would need to spend $5.76 in Zurich, $4.22 in Shanghai, $3.40 in Berlin (almost the same as the U.S.), $2.84 in London and $1.53 in Cairo. These simple comparisons of the price of a good that is available in many countries can be an indicator of whether foreign currencies are over-valued or under-valued relative to the US dollar.
There are some criticisms of these simple tools. Costs of these products can depend on local wages or rents, which are generally more expensive in richer countries and can add to the cost of the product. The price for a Starbucks Latte can even fluctuate amongst American cities or specific locations, like airports, which may have higher rents. And adjusting these indices for GDP will change the data and perhaps improve their accuracy. Some also have pointed to the ingredients in these particular items as causing value differences. McDonald’s, for example, must use strictly British beef in the U.K. Starbucks can be a little more consistent, as coffee beans are not generally grown in most of the countries they operate in, so the imported price is pretty standard.
What these indices don’t tell us about the currency market is why fluctuations occur. For example, why has the U.S. dollar hit a recent three-year low? According to an article in yesterday’s WSJ, one simple explanation for a weakened dollar is that “the economies in the rest of the world are finally growing again, so their currencies are strengthening. The U.S. economy isn’t improving as fast—because it was stronger to start with—so the dollar’s falling.” The Chinese yuan has gained 3.8% so far in January after gaining 6.7% in 2017, which has the officials at the People’s Bank of China concerned about their exports. President Trump and the U.S. have been critical of any Chinese central bank policies that would devalue the Chinese currency and cheapen goods coming into the U.S. This trade friction complicates China’s management of their currency, particularly as they attempt to make the yuan a more market-driven currency.
Adding to the currency gap with China and the drop in US currency values overall were comments made last week by the U.S. Treasury Secretary signaling Administration support for a weaker U.S. dollar as being “good for trade.” Such overt comments are traditionally avoided by the Treasury Department, but may spotlight the Administration goals to reduce the trade deficit and allow currencies to float freely. President Trump reiterated his stance on trade imbalances in his State of the Union address, pledging to “fix bad trade deals” and that he expects trade deals to be “fair” and “reciprocal”. Another factor that may weaken the dollar is the belief that 2018 will bring a tightening of monetary policy by the international banks. Some banks, like the Bank of Canada and Bank of England, have already raised rates.
A weaker dollar makes U.S. goods cheaper to foreign markets, but there is a risk of undermining confidence in an array of U.S. assets, like the U.S. Treasury market. As the WSJ article explained, as the new tax law expands the federal budget deficit, the government will look to sell the debt to foreign investors. Those investors may demand higher rates to compensate for the risks of a weaker currency and those costs could fall onto the U.S. taxpayers.
So, we should think about our American dollar today and perhaps look at our paychecks or tax returns to see what has changed. At DWM, we are always careful to think about each and every one of your dollars – the ones you invest, the ones you save, the ones you spend and the ones you pay in tax. Using the simple Big Mac or Starbucks Latte indices might help us remember all the factors that go into the value of a dollar around the world. For me, I certainly prefer to imagine buying a tall latte in Zurich over a Big Mac!