What the ‘Big Mac’ Index Can Reveal about Global Currencies

George Soros, the world-famous currency speculator “who broke the Bank of England” in 1992, calls investing in currencies “an existential choice.”

No wonder most folks have a hard time getting their heads around the $5-trillion-a-day world of currency trading. Nevertheless, the second half of 2014 was the most exciting time in major global currencies in recent memory.

Thanks to a stronger economy and falling oil prices, the U.S. dollar has soared 15% over the past six months. Meanwhile, the euro has tumbled by 17% in anticipation of the European Central Bank’s recent entry into the quantitative-easing game. The relentless drop of 14% in the value of the Japanese yen over the past six months was almost as sharp.

Finally, there was the dramatic jump of 13% in a day in the Swiss franc last week, when the Swiss National Bank abandoned its currency’s peg to the euro.

Not to be outdone by the less virile West, Vladimir Putin helped beat the Russian ruble down by roughly 50% over the past six months.

The last time I was in Moscow, it was more expensive than London or New York. Today, it’s cheaper than global centers like Krakow, Poland, or Colombo, Sri Lanka.

Enter the Economist’s Big Mac Index

One of the best ways to get your head around relative currency valuations is to look at what the same goods cost in Chicago, London, Tokyo and Beijing.

Britain’s Economist magazine has done so since 1986 with its now-famous Big Mac Index — a tongue-in-cheek but surprisingly useful way of measuring purchasing power parity (PPP) — that is, the relative over- and undervaluation of the world’s currencies compared to the U.S. dollar.

By comparing the cost of Big Macs — an identical item sold in about 120 countries — the Big Mac Index calculates the exchange rate (the Big Mac PPP) that would result in hamburgers costing the same in the United States as they do abroad.

Compare the Big Mac PPP to the market exchange rates, and voilà!… you see which currencies are under- or overvalued.

Global Currencies: The Current State of Play

I have been studying the Big Mac index closely for about a decade. And in the past year, I’ve seen the most dramatic movements yet.

Let’s take the example of Europe. Seven years ago, the euro was overvalued by a massive 50% compared to the U.S. dollar. Last year, the European currency was 7.8% overvalued. Today, it is 11% undervalued. It is time to take that European vacation!

Back in 2007, the British pound hit 2.10 U.S. dollars to the Great Britain Pound (GBP) and the United Kingdom was one of the most expensive places on the planet. After the Great Recession, the GBP tumbled to about $1.35. Today, it’s back down to $1.50. In the current survey, a Big Mac actually costs 8.8% less in the United Kingdom — $4.37 — than it does in the United States, where a Big Mac sells for $4.62 (By the way, the cost of a Big Mac in the United States rose 3.7% in 2014 on top of a 5.72% rise over the previous year — both substantially higher than the headline U.S. inflation numbers).

The Big Mac Index: Few Overvalued Currencies

Not surprisingly, the Swiss franc is the most overvalued currency in the world — though at 57.5% overvalued, it’s just 3% higher than last year.

As a group, the Scandinavian currencies have always been at the top of the charts. A Big Mac in Norway today is 31.5% more expensive than in the United States. But that is down from 68.6% last year. Sweden and Denmark come in at a mere 2.7% and 12.2% undervalued, respectively. Once again, this is a far cry from the 36% and 12% overvalued levels, respectively, you saw last year at this time in the currencies for each of those countries.

Brazil’s currency — the real — rounds out the ranks of overvalued currencies. Four years ago, the Brazilian real was 52% overvalued on the Big Mac Index. Today, the real is 8.7% overvalued compared to the U.S. dollar.

The Big Mac Index: A Slew of Undervalued Currencies

The biggest changes in the past year have been the widespread devaluation in both developed and emerging markets’ currencies. I’ve already touched on the dramatic drop in the euro and the yen.

For most of the past decade, the Chinese yuan has been consistently the most undervalued currency in the world. Today, it is far from that. But that has nothing to do with the Chinese. The Chinese yuan remains remarkably stable, still trading 42.2% below its PPP rate, pretty much where it has stood for the past five years.

Today, a whole slew of emerging markets’ currencies are now cheaper than the Chinese yuan. Russia, India, Hong Kong, Indonesia, South Africa and India are all top emerging markets that are more undervalued than the yuan.

The Big Mac Index: What You’d Trade Today

So, if you were running a currency hedge fund and using the principle of buying undervalued currencies — and selling the overvalued ones — here is what you’d do.

Among the “big six” currencies favored by foreign-exchange traders, you’d sell the Swiss franc (FXF) — the only major currency that is massively overvalued. You’d ignore the British pound sterling (FXB) and the Canadian dollar (FXC), which are roughly within 10% of their PPP values. The euro (FXE) and the Japanese yen (FXY) would be long bets based on their current undervaluation of 11% and 34.4%, respectively. But with both the European Central Bank and the Bank of Japan committed to driving the euro and yen down further, you’d have to be a real contrarian to pursue these trades.

Looking at less mainstream currencies, you’d buy the Chinese yuan (CYB) (42.2% undervalued), the South African rand (SZR) (53.6% undervalued), the Mexican peso (FXM) (30.1% undervalued) and the Indian Rupee (ICN) (60.6% undervalued).

My top recommendation to my subscribers is to continue betting on the greenback’s rise against the broad U.S. Dollar Index through the PowerShares DB US Dollar Bullish ETF (UUP).

After all, the U.S. Dollar Index is only back to where it was in March 2009, right when global stock markets bottomed.

But that also means the U.S. dollar is still 25% below its 2001 peak — and 50% below its peak in the 1980s.

Predictions about the demise of the dollar notwithstanding, the greenback has a way to go.

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In case you missed it, I encourage you to read my e-letter column from last week about India’s remarkable political climate and recent ascent. I also invite you to comment in the space provided below my commentary.