What Big Macs reveal about the euro

According to The Economist's Big Mac index, the euro and a basket of other global currencies are overvalued. But how reliable is this signal?

Currency analysis using burgers

Currency movements can be predicted using two tools. First off there's fundamental analysis. For a company this would mean looking at key ratios such as price-to-book, or price-to-earnings. However, for a currency it means "bottom-up" economic analysis to decide whether one is over- or under-priced in relation to another. That's where the so-called Big Mac index, published by The Economist for the last 24 years, comes in.

The joy of purchasing power

The concept behind the index is simple enough. You take a product that is pretty much identical the world over, consumed by large numbers of people (so it's relatively cheap) and is made more or less the same way no matter where it is sold. The Big Mac produced in around 120 countries fits the bill. Purchasing power parity theory says that, in the long run, exchange rates should move so that prices for given goods are the same everywhere. In other words, consumers in countries (ideally with relatively equal levels of per-capita income) should expect to pay about the same for a Big Mac when the price is measured using a single yardstick the US dollar. If a Big Mac is significantly cheaper in one country, the currency must be too low and can be expected to rise, and vice versa.

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The latest results

According to the index, the cheapest place to buy a burger is Asia. In China, for example, a Big Mac will set you back $1.95 at current exchange rates, whereas in its heartland the US you'll pay more like $3.73. That difference could suggest that the Yuan is about 48% undervalued in spite of China's efforts to move towards a freer exchange rate. Other emerging markets such as Thailand, South Korea and Argentina also appear to price a Big Mac too cheaply in US dollar terms. So their currencies could rise too.

As for overvalued currencies, the Brazilian real is the only emerging market currency to stand out according to The Economist, "burgernomics suggests that the real is overvalued by 31%". Over in Europe it's the euro that looks toppy having been 50% overvalued against the US dollar two years ago, it is still around 15% overvalued now. But the overall European awards for burger costliness go to Sweden (76% overvaluation), Switzerland (68%), and Norway (93%).

The index also reveals some interesting shifts. For example, two years ago a Big Mac cost more in Budapest, Hungary, than it did in London. Today that position has reversed. Indeed, most of the Baltic countries are almost as cheap as Asia. Finally, anyone wondering why one of the most important BRICs is missing India needs to remember that Hindus don't eat beef and that this country's rather different chicken alternative the Maharaja Mac is excluded.

Does this index help a currency trader?

After 24 years the index has become a rough-and-ready guide for anyone looking to spot long-term currency trends. But short-term traders planning on, say, shorting an overvalued currency, such as the Swiss Franc, beware.

First, differences in the price of a Big Mac are not fully explained by exchange rates. The burger may simply cost more or less to produce in one country than another. That's down to factors such as cheaper local labour and raw product costs (beef is very cheap in Argentina, for example), different tax policies (not all countries tax hot food the same way); brand awareness (the McDonald's brand is more positively perceived in some countries than others, which affects the amount consumers are prepared to pay); and even regulations (in Scandanavian countries, for example, import tariffs can be high).

Besides, there may be good reasons why a currency that is apparently "overvalued" might stay that way for some time. Take Norway, for example its currency attracts a premium to reflect its relative political stability, high disposable income, low unemployment, and low national debt. Plus it is a huge oil exporter relative to its size. Equally, Switzerland is traditionally viewed as a 'flight to safety' market in times of trouble (which pushes up the Swiss franc), even when its economy isn't in great shape.

The alternative technical analysis

As a rough guide to the long-term likely direction of different currencies' purchasing power, parity benchmarks such as the Big Mac index are fine. However, shorter term you are better off using technical analyses or charting (see www.moneyweek.com for more

on this). As a rule of thumb ,"the trend is your friend", and once major currencies such as the euro start appreciating or depreciating, they tend to stay on the same trend for some time. Keep an eye on key economic data, such as payrolls (the US non-farm data can have a big impact on the dollar), as well as central bank news linked to interest rates (Brazil, for example, has a base rate of 10.75% if that drops, so will its currency).

How to play currencies

There are several options when it comes to trading currencies, including exchange-traded funds. However, the least complicated and typically cheapest option is the currency spread bet. According to the Big Mac index, heavily undervalued currencies relative to the US dollar include the Chinese yuan (CYB), the Russian ruble XRU), the South African rand (SZR) and the Mexican peso (FXM). Expensive currencies are the Swiss franc (FXF), Swedish krona (FXS) and the Brazilian real (BZF).

However, the best target at the moment looks to be the euro (EUR). As sovereign-debt woes continue to haunt Europe, more weakness is likely. A long GBP/EUR trade could be a winner.