Simon Hudson-Peacock, consultant to SFP, continues his discussion on exchange rates.

Pricing in Market Expectations

In the first part of this exchange rate review two weeks ago, I introduced a concept of a “fair value” exchange rate; the purchasing power parity exchange rate (PPP). This theoretical exchange rate between two countries is based on the principle of being able to exchange two identical baskets of goods priced in the respective country’s local currency. Because the basket is identical, one should be indifferent as to which basket one holds and therefore the values of the basket should be equivalent albeit in different currencies. Hence a ratio of the two values would suggest a fair exchange rate.

However we saw that, in the case of South Africa against the USA, the actual exchange rate was almost double that of the PPP exchange rate and we wondered why. Partly this is due to the fact that trade between the US and South Africa is not perfectly frictionless. One can’t sit in New York and decide to buy the South African basket instead of the local one. A common basket of goods does not exist and even if it did there are practical considerations; time delays, transport costs and trade barriers. Therefore seemingly large valuation disparities can and do persist.

We may derive a theoretical value for almost anything but, as so often happens, market forces dictate the actual price. In the six months leading up to Christmas 1975, Gary Dahl from the USA marketed and sold smooth pebbles from a Mexican beach branded as Pet Rocks (complete with care manuals and training tips on how to make your pet “sit”, “stay”, “lie down” and “roll over”). They were so obviously worthless but he managed to sell 1.5 million of them at US$4 a piece (almost US$20 per pet (R300) in today’s terms – go figure!). Beauty is truly in the eye of the beholder

Currencies behave like many other financial assets (and indeed Pet Rocks); the relative price, in our case the exchange rate, is determined by the relative supply and demand of the two currencies entering into the transaction. If you want something badly enough you’ll pay up for it, if not, you’ll give it away. So, it follows that the reason that South Africa’s exchange rate is so far away from its theoretical PPP fair value is because it is not in high demand (or is in excess supply) relative to, in this example, the US$.

Now in order to understand why a currency may be relatively attractive or not, we need to look at the mechanism by which financial market participants set asset prices. Here we enter the rarified world of “future expectations”. The price of a financial asset moves today because of news flow that affects our perception of what it might be worth tomorrow. It becomes more or less attractive to us and accordingly its value moves up or down.

Say you owned a Pet Rock during those heady six months in 1975 and you heard that the company who supplied them had run out of pebbles in the lead up to Christmas. All of a sudden, your pet rock is worth way more than you paid for it! Conversely, if you received news that the company was struggling to sell their rather somnolent substitute companions, then surely the price would fall.

With exchange rates, it is the future expectations of relative inflation between two countries that moves the price. I need to go back to the PPP theory to explain this. If South Africa’s inflation rate is expected to be 10% over the coming year, it is reasonable to assume that the “basket of goods” upon which the PPP rate is calculated may be expected to cost 10% more in Rands in 12 months time. Similarly, if the US inflation rate is expected to be 2%, then their identical “basket of goods” might be expected to cost 2% more in US$ in a year’s time. It follows then that the PPP exchange rate between the two countries in a year’s time is expected to be 8% lower (10% – 2%) in order to maintain its fair value over this time frame.

But, inflation expectations change over time and therefore so do expectations about future exchange rates. If inflation expectations deteriorate then the relative exchange rate will be expected to depreciate at a faster rate. Referring to the PPP discussion two paragraphs above; if South Africa’s inflation rate expectations increase to 20% over the coming year in the above example (from 10%) then the depreciation, in theory, will be expected to be 18% rather than 8% over the coming year.

It’s a little more complicated than that, but investors can and do take advantage of these changes in expectations. In the next Exchange Rate discussion, I’ll look at how investors try to trade currencies for profit. Unfortunately I’m not going to be able to provide you with a tool to make your millions (be very wary of those companies who say they can!). News flow changes expectations and we can’t predict news flow; news is “new” after all. But hopefully you will have a better understanding of how news flow impacts inflation expectations and therefore how it impacts the exchange rate. Exchange rate volatility will then hopefully not seem so vague and scarily unpredictable.