How Does the Dollar Stack Up Historically?

11/13/2009 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

Even though it has been a relatively quiet news week in the foreign exchange markets, the sharp intraday reversal of the US dollar has caught the eye of many currency traders. After falling within a whisker of its 15-month low against the euro, the dollar changed course and rose aggressively against most of the major currencies, turning profits into losses. The currency that dropped the most against the dollar was the British pound and the only currency that managed to hold onto its gains was the Canadian dollar.

No major US economic data was released and equity markets will probably close the week in positive territory. The latest pieces of economic data from China were strong with industrial production rising more than expected. This means that there is no "fundamental" reason for why the dollar has recovered. Instead, the most practical reason is simply profit taking around key levels. The 1.50 mark has been a tough barrier for the EUR/USD to break, and so far, it has not been able to close above that level in more than two weeks.

With no major dollar-related news, we take this opportunity to compare how the dollar stacks up historically. Recently, there have been a number of economists talking about the "historical average" of various currencies. For example, Barclay's chief Japanese FX strategist recently said that the reason why the Japanese government has not intervened in the yen is because the yen's value is "close to its long-term basis."

We are not sure where this observation comes from since the current level of USD/JPY (89.84) is far from its historical 30+ year average of 175. The yen is also overvalued compared to its historical average against the British pound and Australian dollar. EUR/JPY is the only currency pair that is trading close to its historical average of 131. The data also diverges significantly from purchasing power parity, which is also another long-term way of looking at currency valuation.

For example, according to PPP, the least overvalued G-10 currency is the Japanese yen, but the yen has the largest gap between its current price and its historical average. In our opinion, "historical averages" are not very applicable to forecasting exchange rates, but they nonetheless provide context and we leave it up to our readers to decide whether or not the data can be a helpful guide of future price action. We believe that the dollar could fall another five to seven percent, as I mentioned in yesterday's currency corner article.

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