On Thursday, UBS released a report presenting a less extreme valuation of the US dollar compared to simple purchasing power parity (PPP) models.
The company’s preferred valuation metrics show the dollar overvalued by about 2.5% relative to the Federal Reserve’s narrow trade-weighted index (TWI) and about 5.5% overvalued by the dollar index (DXY). This contrasts with the 20-25% overvaluation suggested by PPP models.
UBS’s assessment suggests the dollar’s strength may continue as the case for a quick return to what is considered fair value is less compelling. The company’s adjusted PPP estimate fell to about 1.12, well below the Organization for Economic Co-operation and Development’s (OECD) unadjusted estimate of 1.50 and the pre-COVID model value of 1.22.
The report noted that the euro faced significant challenges, including a negative terms of trade (ToT) shock and lagging growth compared to the US. These factors have contributed to the downgrade, with UBS suggesting that 1.12 may be a more realistic medium-term target for EUR/USD in scenarios where economic conditions in Europe improve significantly.
Similarly, the value of the Japanese yen was impacted by ToT, although it did not face as big a headwind to growth as the euro. The adjusted PPP for is about 122, which is higher than the PPP of about 95.0. This suggests that the yen is about 25% undervalued relative to the current spot rate. UBS notes that factors such as interest rate differentials not included in the model likely account for much of this underestimation.
UBS predicts that the yen’s undervaluation against the dollar may continue in the near future, as a significant reduction in the dollar’s yield advantage currently appears unlikely. This is consistent with the bank’s updated currency forecasts, which imply the current differences in valuations could continue for some time.
InvestingAbout Insights
Recent data from InvestingPro shows that the US dollar, as measured by the Dollar Index (DXY), has experienced fluctuations in its valuation over different periods of time. The total weekly price return as of day 109 of 2024 is a modest 0.58%, indicating a slight increase in the value of the dollar. Looking at the broader time frame, the year-to-date (YTD) total price return shows a stronger rise of 4.45%, suggesting stronger dollar performance YTD.
Interestingly, the six-month total price return shows a slight decline of 0.63%, which could indicate some short-term pressure or correction from the previous rally. However, if you extend the perspective to one year, the dollar’s strength is clear, with a total return of 4.07%. DXY’s previous close was $105.95, reflecting the current strength of the dollar.
InvestingPro’s advice notes that traders should consider both short- and long-term trends when assessing currency strength, as different time frames can reveal different market sentiments and potential turning points. For those who want to dive deeper into currency analysis, InvestingPro offers an additional 15 tips that provide insight into trading strategies and market trends.
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