Splat

Mmm… not quite, Capo.

With the Euro at $1,35 +/- $0.02, real value, or in this case Euro overvaluation can be found in Purchasing Power Parity, explained simply thus:

The Euro corrected lower in December but remains significantly overvalued against the US Dollar with prices still over 20% above the PPP-implied “fair” exchange rate. The single was the second-worst performing currency against the greenback last month while the spread between 1-year priced-in interest rate expectations for the Federal Reserve and ECB as narrowed substantially as US data took on a firmer tone, suggesting both momentum and yield considerations are supportive of further losses. The critical thing to keep watch out for as 2010 gets going will be whether the market will return to a risk vs. safety dichotomy that characterized much of the previous year or extend the shift towards a focus on economic fundamentals that began to take root towards the final weeks of 2009. The former scenario would offer some support to the single currency, while the latter would allow for continued weakness. On balance, our bias remains bearish.

What is Purchasing Power Parity?

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 Bloomberg. We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar.

While the Euro has been flying to as high as $1,65, PPP has been consistent at a range of $1,10 - $1,13. The difference is the extent to which Euro-zone occupants are being screwed more than Americans by taxation, cronyism, and “Syndicalism”.

The irony of all of this is that while the Euro rises, the population doesn’t benefit. Not only has it the effect of flattening exports, it costs more and more in Euros to budget what’s expressed in that $1,13 of parity. The money has to leave the Euro-zone and go just about anywhere in the world to get a parity advantage.

Note too: keep an eye out for all of these issues on 19-March and slightly before. It’s the date some Greek government debt comes due, and the auctions will reveal much of what could underlie the coming weeks and months.