01/31/24 09:05 AM EST

Big Mac Index: Using Burgernomics to Break Down Currency

Below is a chart and brief excerpt from today’s Market Situation Report written by Tier 1 Alpha. If you’re interested in learning more about the Hedgeye-Tier 1 Alpha partnership, there’s more information here.

It's Fed day, known for its potential to stir currency markets, we're doing something completely different by delving into the Big Mac Index, a bit of classic Burgernomics. This quirky tool was devised by The Economist back in 1986 to gauge currency valuation. Leveraging the principle of purchasing-power parity (PPP), the Big Mac Index is predicated on the idea that exchange rates ought to evolve to a point where a comparable basket of goods and services (in this instance, symbolized by a burger) would cost the same in two different countries. The Big Mac is utilized as a standard reference due to its near-global uniformity, comprising a bun, cheese, a couple of beef patties, lettuce, special sauce and a caloric count akin to that of a small nation.

Traditionally, the U.S. dollar tends to strengthen during significant market downturns, as indicated by the grey areas denoting recessions on the broad dollar index chart. The Big Mac Index calculates the relative buying power of various currencies with the assumption that the dollar's value remains steady.

In the most recent Big Mac index update, currencies from Switzerland, Norway, and Uruguay appear as the most overvalued in relation to the USD, while those from Taiwan rank as the most undervalued. For instance, buying a Big Mac in Switzerland will set you back 43% more than it would in the United States. That Taiwanese 巨无霸 will cost you only 42 cents on the dollar. No wonder China wants in.

Zooming in on the Australian dollar, those with memories of the pre-Global Financial Crisis era will recall the Aussie as a favored base currency against the Japanese Yen for the carry trade, which involved leveraging the interest rate differential between the two. This strategy attracted significant capital flows, enough to propel the AUD/USD exchange rate to 1.1000. Back in 2011, the Big Mac Index suggested that the Aussie was 40% overvalued against the dollar. Today, it is considered 10% undervalued by the same burgernomic standards, while the AUD/USD has fallen 50% from its carry trade heydays. Consistent with Big Mac math.

However, don’t bet your life savings on a Swissy short based on burger math, there are inherent flaws in the Big Mac Index. The retail price of a Big Mac is influenced by various local factors, such as production, distribution, marketing expenses, transportation and local market conditions, which differ from country to country and don't necessarily reflect true currency value comparisons. Additionally, Big Mac prices may fluctuate based on the locale, potentially costing more in metropolitan areas compared to rural settings. Remember, arbitrage is useful for thinking about the conditions that both hold and do not, often defining the limits to trade.

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