FOREX relative buying power

Greetings all,

Here’s a question you may have considered at one time or another, especially if you trade FOREX. If the EUR/USD rises, is it because the Euro is strong and the USD is weak? Or is it because they’re both strong, but the Euro is just a little stronger? Or is it because they’re both weak, but the USD is just a little weaker?

Well which is it? How can you tell? And does it matter? And will I ever stop bombarding you with questions?

I started considering these questions at the end of 2008, and my solution was to determine a currency’s strength by looking at its buying power in terms of some base commodity. Back then I just used the price of oil as the base since it’s a widely used global commodity with an easily accessible spot price. The idea isn’t new; it’s basically the “Big Mac Index” idea using a more sensible base product (although I do find Big Macs tastier than oil barrels). The concept is easy to describe arithmetically.

Suppose that on Friday, September 2, the price of oil is $100/bbl and the EUR/USD is at 1.5000. Then imagine that a week later, on September 9, the price of oil is $90/bbl and the EUR/USD is at 1.6000. The dollar is clearly stronger, because it can buy more oil. But the Euro has clearly still gained on the dollar, so the Euro’s buying power with respect to oil has increased even more than the dollar’s.

Specifically, the dollar’s buying power has increased by:
100/90 – 1 = 11.1%
The Euro’s buying power with respect to oil has increased by:
(100/90) x (1.65/1.50) – 1 = 18.5%

So in this case, the answer to our opening question is that both currencies are stronger, but that the Euro has gained the most in strength.

Back in 2008, I used this approach to keep track of the relative buying power of 8 major currencies, and attempted to incorporate this into my trading as described in  my Forex Factory Journal  (yes, I’ve been on FF for years). I didn’t really do much with it at the time, and I was never satisfied with using just oil as a base. It wasn’t diversified enough and was too volatile to be a really good indicator of buying power.

In recent weeks I’ve been planning to revive this “relative buying power” concept, and I just began work on it again over the past few days. In the next few posts in the Research category, I’ll describe this research and hopefully the construction of a new tool for the trading dashboards too.

So stay tuned, and keep pipping up!

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