In todays’ chart we show the USD/ZAR exchange rate (green line) in comparison to our internally developed ‘fair-value’ model (dark black line) over the past twenty years. This fascinating chart highlights the critically important point that currencies are mean-reverting.
This important statement holds true because the flow of trade, level of consumption and foreign direct investment are all decisions made by participants in the economy – meaning they are flexibile and generally made to maximise prosperity given the current circumstances. For example when a currency is weak, consumers spend less on imported goods (too expensive) and exporters sell more as their goods (cheaper than rest of the world) – this naturally improves the trade balance. A better trade balance results in better fundamentals which will result in renewed investment and a subsequent strengthening of the currency (reverting back to the mean).
This analysis holds true except for the exceptional cases where the country in question turns into a ‘failed state’ – Zimbabwe and Venezuela come to mind and here the expectation of a mean reverting currency is impaired.
Author: Callan Williamson, CFA
Source: Efficient Select