FOREX Relative Buying Power — Part 2

Hello again!

This is the second in a series of posts about my recent research on FOREX relative buying power. In the previous post, I discussed how I dabbled with this concept back in 2008. Now let’s look at last week’s revival of this research. For more detail, you can download the accompanying spreadsheet.

Take a look at this chart, and ignore the “Prior 52 weeks” in the heading for now. Below is the story behind the chart.

Relative Buying Power chart

New & improved base

Back in 2008, I used the price of oil as my baseline to determine the change in each currency’s buying power. To achieve a more realistic and diversified baseline, I’m now using the Thomson Reuters/Jefferies Conference Research Bureau Commodities Index (TR/J CRB).

This index has several versions apparently, and I’m specifically using the tenth revision. According to the Wikipedia entry, “The index comprises 19 commodities: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gas and Wheat.”  So here we have valued goods that money can buy; food, industrial metals and fabrics, precious metals, and energy.

Because global commodities are most often priced in U.S. Dollars, I consider the index value to be the price in dollars of a given basket of these commodities, weighted as they are in the index. So if the index is at 300.00, this means that our “standard basket of stuff” currently costs $300. See? Si, I see!

Data

Investing.com is the best.  Site.  Ever.  And they don’t even pay me to say that! Anyway, that’s where I went to get the historical price data on the TR/J CRB index and the eight currencies I looked at. I used weekly prices as of the close on Friday (the site actually uses the date for the starting Sunday of the week, so I just converted it in my spreadsheet).

The TR/J CRB index data only went back to May of 2013, so the first week in my dataset is the week ending Friday, May 31, 2013. I could actually have gone back to May 10, and I don’t remember why I didn’t. Anyway, the raw data consists of the closing prices of the TR/J CRB index, EUR/USD, GBP/USD, USD/JPY, CAD/USD, USD/CHF, AUD/USD, and NZD/USD. The last record is for the week ended Friday, March 21, 2014, for a total of 43 weeks.

Relative Buying Power

First, I wanted to view the overall change in each currency’s buying power relative to the beginning of the data. Eventually I’ll be doing this for the trailing 52 weeks, but I don’t quite have 52 weeks yet. This is why the chart makes reference to 52 weeks at the top, even though it doesn’t go back that far.

For the USD, the change in buying power is just the change in how many “standard baskets of stuff” we could buy with a U.S. dollar. If the TR/J CRB index has gone down, the buying power of the USD has gone up, and vice-versa. The TR/J CRB index was at 281.85 at the end of the first week, and this is the base value we use for all the following weeks. So we’re not looking at the week to week change; we’re looking at the change relative to the first week in the data (which eventually will always be 52 weeks ago).

For example, at the end of week #2 the TR/J CRB index is at 287.67, so the value of the USD has dropped. In percentage change terms this is:

281.87/287.67 = 0.98 (a 2% drop in buying power)

Note that we always put the current index value in the denominator, because higher commodity prices imply a lower value for the USD. Similarly, a few months later on November 1, we have an index value of 274.96, so at this point the USD is up 4% in value relative to the first week:

281.87/274.96 = 1.04 (a 4% rise)

But what about the other currencies? Let’s look at the Euro on November 1 as an example. We know that the value of the USD relative to May 31 is 1.04, but how has the value of the Euro relative to the dollar changed during this period? On May 31 the EUR/USD was 1.2996, and on November 1 it was 1.3492. The Euro has gone up in value against the USD:

1.3492/1.2996 = 1.038 (or up 3.8% against the dollar).

Note that for pairs where the USD is the counter currency (such as EUR/USD, AUD/USD, etc.) we put the current quote in the numerator. For USD/JPY and USD/CHF however, we would put it in the denominator.

So now that we know how the USD changed against commodities, and how the Euro changed against the dollar, we just multiply the fractions together to get the total change in the Euro’s buying power against the commodities:

(281.87/274.96) x (1.3492/1.2996) = 1.064 (a 6.4% rise in buying power)

A more explicit (but more combersome) way to think about this is to imagine that you have a Euro on May 31 and you keep it until November 1. How much has your buying power in terms of commodities (actual valuable “stuff”) changed in that time?

On May 31 you could buy $1.2996 with your Euro. With that money, you could buy a little piece of our “standard basket of stuff” which costs $281.85 at that time:

1.2996/281.85 = 0.004611 “baskets” on May 31

But if you had kept your Euro until November 1, it would be worth $1.3492. And since our “standard basket of stuff” costs only $274.96 on that date, you could buy:

1.3492/274.96 = 0.004907 “baskets” on November 1

The amount of “stuff” you can buy with a Euro has gone up:

0.004907/0.004611 = 1.064

This is the same increase of 6.4% that we saw using the simpler method. Doing this for all eight currencies for all 43 weeks in the data gives us the chart at the top of this post.

Whew!

That’s quite enough for now! Good grief! Time for a nap! Or an aspirin! Or maybe some yummy lunch!

Right. In the next post I’ll describe more analysis I did on this data in order to “weaponize” it into a useful trading tool.

As always, stay tuned and…keep pipping up!

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