How we rank currencies:
Value - Purchasing Power Parity (PPP)
One of the oldest and most basic fundamental approaches to determining the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. For example, if a pencil costs €1 in Europe and $1.20 in the US, the “fair” EURUSD exchange rate should be 1.20. For our purposes, we will use the PPP values provided annually by the Organization for Economic Cooperation and Development (OECD). We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar, then rank them from 1-7 based on the idea that we want to buy the cheapest (most under-valued) and sell the most expensive (most over-valued) currencies vis-à-vis the greenback. Currencies overvalued against the Dollar are denoted in RED, while those that are undervalued are denoted in GREEN.
Yield - 12 Month Interest Rate Expectations
Central bank interest rates reflect the return an investor can earn by owning the corresponding currency. This typically drives up demand for currencies that pay higher interest and reduce demand for those that do not. Because markets are forward-looking, traders tend to focus on interest rate expectations as indicative of future demand for a given currency, with higher rates tending to cause appreciation and vice versa. For the purposes of relative ranking, we look at overnight index swaps to gauge the market’s expectations for changes in the difference between the US Fed’s interest rates and those of the top 7 major currencies over the next 12 months. We then rank them 1-7, assigning the lowest (least favorable) scores to those that will see the yield gap shift the farthest in favor of the US Dollar. Changes in favor of USD are denoted in RED, while those in favor of the currency in question are in GREEN.
Performance – Monthly % Change vs. US Dollar
It is important to recognize that sometimes currencies make significant moves without a clearly defined catalyst. Rather, price action feeds on its own inertia to pick up strong directional momentum. To capture this and include it in our valuation, we rank each currency based on its accomplishments against the US Dollar in the previous week and assign a score of 1-7 with the highest marks going to the best performer.