Comparing Currencies With Burgers
The Economist magazine regularly compiles a table of Big Mac prices across the world. The idea is to see if exchange rates are under- or over-valued against the US Dollar using a simple good. The latest data (Jan 10, 2019) shows Pound Sterling undervalued by a whopping 25%. Does it mean that one could profit from buying Sterling?
What is the Big Mac Index?
In foreign exchange, one of the theories that governs exchange rates is the Law of One Price. This means that the same good should cost – roughly – similar.
Take McDonald’s Big Mac as an example. In theory, the burger should sell at the same price around the world because it is a homogeneous good. The only difference is the exchange rates. Taking this idea further, in 1986 The Economist magazine went to collect Big Mac prices globally and see how much price variation there were on the same burger. It produced eye-popping price differences. The Big Mac Index was born – and after 32 years, the Big Mac Index is still in existence (click here).
Sterling Undervalued By 25% On The Big Mac Index
According to the latest data, Sterling is now undervalued by a substantial 25% against the US Dollar. How so? In the UK, a Big Mac costs £3.19. Across the Atlantic, US$5.58. The implied exchange rate is 3.19*1.749 = $5.58.
At the current exchange rate of 1.300 (rounded up), Sterling is cheap – since a Big Mac, in Dollar terms, cost only $4.15 (£3.19*1.300 = $4.15). The difference between the two rates is about 25% (see below).
Source: The Economist
What is causing this undervaluation of Sterling? Two answers: Brexit and interest rates.
Specifically, Brexit prompted investors to sell Sterling into USD due to higher economic uncertainties. Accentuating this trend are higher US interest rates (10-year US bond yields hover around 3%).
How Reliable is the Big Mac Index for Ttrading and Investing?
The key question is this: Can the Big Mac Index be used to trade FX rates profitably? Remember that the Big Mac Index is a price comparison tool using only one good. The data does not include interest rate differential, or costs differential, or tax differential. So when using the Big Mac Index, bear in mind three points:
- Currencies can remain undervalued/overvalued for some time;
- Currencies can swing from undervaluation to overvaluation. They seldom trade at ‘average’ valuation;
- Trade frictions are real. The Economist‘s burger index is only a very crude measure.
Take Sterling. Right now, it is pinned down by Brexit. This process could last for years. Hence Sterling’s undervaluation will persist until a market/economic catalyst change the fundamental picture. One such catalyst could be the abandoning of Brexit.
On a day-to-day basis, the Big Mac Index is not very helpful because other events impact prices greater, such as market risk sentiment, monetary policies, or inflation data.
Therefore, even though the Big Mac Index is a useful guide about a currency’s valuation against the greenback, it should only be used as trading guide.
Where to trade currencies against the Big Mac Index
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