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Last Friday, I suggested that the dollar was still very weak against a large basket of currencies. This post focuses on the dollar's value vis-à-vis the British pound.

(click to enlarge)

The green line in the above chart is my calculation of the purchasing power parity (PPP) of the dollar/sterling exchange rate. This is the rate that in theory would make prices equal between the two countries. At this rate, U.S. tourists to the U.K. would find that on average goods and services cost about the same there as in the states. The rate is calculated by using a base year for the exchange rate (i.e., a period during which prices where roughly equivalent between the two countries) and adjusting that rate by the difference in inflation over time between the U.S. and the U.K.

The PPP of the pound has been falling over the entire period of the chart, which means that inflation in the U.K. has been higher than inflation in the U.S. So the PPP value of the pound must fall in order for prices to remain equal (i.e., the weaker PPP value of the pound offsets the higher nominal prices in the U.K.). As a rule of thumb, significant deviations between the value of a currency relative to its PPP value reflect stronger/weaker demand for the currency, which in turn is related to confidence in a country's fiscal and monetary policies, and/or the outlook for the economy.

Currently, I estimate that the pound is about 10%-15% overvalued relative to the dollar. If I'm right, that means that goods and services cost about 10%-15% more in the U.K. than they do in the U.S. This is down significantly from the 40% overvaluation of the pound in late 2007. The dollar was weak against almost all currencies back then, and it had been falling for the previous five years. The euro was also quite strong at the time, and Eurozone equities had outperformed U.S. equities for five years running.

As I see it, the world was much more optimistic about the future of Europe at the time than about the future of the U.S. Today the world is losing its enthusiasm for Europe as the list of things to worry about (relatively high public debt/GDP ratios, relatively high tax rates, large unfunded pension liabilities, sovereign debt defaults, a potential breakup of the ECU, the inability of most states to cut back on excessive public sector spending, etc.) lengthens. Meanwhile, things haven't been as bad in the U.S. as had been expected.

If the U.K.'s troubles prove to be deep-seated, intractable, and worse than the troubles still plaguing the U.S., then the pound is likely to fall further against the dollar. In a worst-case scenario, there is little reason why the pound couldn't again approach parity with the dollar, as it almost did in 1985. For the time being, I'd be reluctant to be long the pound vis-à-vis the dollar. U.S. investors would be wise to ensure that any investments they have in Europe or the U.K. are not exposed to currency risk. U.K. investors might want to leave the currency exposure of any U.S. investments unhedged.

Source: Sterling Update: Still Somewhat Expensive