Trading your rands for US dollars is like climbing into a warm bed; you feel protected, secure. And it looks like an especially cosy trade right now with a booming American economy and scheduled rate hikes lined up to support its currency.
But, as much as our aching bodies (and minds!) yearn for the comfort of the US dollar, we’re finding it very difficult to climb in; the bed (valuation) looks too high.
“Value” is the starting point of every investment we make and it’s particularly important when investing offshore. Any asset (cash, bonds or equity) denominated in an expensive currency (at the time of investing) is at risk of performing poorly if that currency moves from an expensive valuation to an average, or cheap one. You would expect this to happen if you believe in mean reversion.
So how do we get a feel for the valuation of the US dollar? By using inflation data. To geek out on this a bit, the theory is that if the US has a higher inflation rate than say Japan over time, then the US dollar should depreciate against the yen in the long-run. This keeps the purchasing power of the dollar and yen in equilibrium, preventing arbitrage opportunities. Ask us for the mechanics behind this if it doesn’t make sense.
The red dotted line in the chart below is the fair value (neither expensive nor cheap) of the US dollar in relation to the currencies of its major trading partners. The downward slope means that over time the US dollar should depreciate against the other currencies – why? Because on average it runs a higher inflation rate.
The parallel black lines mark one standard deviation from the fair value. Mathematically, this means that 68% of all the historical data points that constitute the blue line fall within the two black lines. Said another way, if the US dollar remains tethered (albeit loosely) to inflation fundamentals as it has in the past, then at any point in the future, it has a two thirds chance of trading within one standard deviation of its fair value. Today, the US dollar is above one standard deviation expensive.
We’d be foolish to conclude that the US dollar must weaken from here – currencies have and will continue to take extended leave from their fair values. But at these levels of valuation there would need to be very specific circumstances in place before we could trade our rands for assets denominated in US dollars; perhaps the most important would be a meaningful slowdown in global growth.
With that caveat in ink, let us summarize with the following: The comfort of a bed does nothing to cushion the floor when you fall out of it.