Exchange Rates: GDP Output Gap

Buy when the yellow line is low, sell when it is high

Sample chart showing the correlation between exchange rates and the difference in spare capacity between countries. Where forecast, the series changes from yellow to orange.

This valuation strategy reveals the effects of differences in the pressure of demand between economies, as expressed in the amount of spare capacity, based on our own calculations for the Output Gap.

The exchange rate is shown as the thick white line on the right hand axis. The explanatory variable, domestic less foreign spare capacity, uses the left hand axis, shown as the thin yellow line. A Best Guess as to the future development of the variable is also shown on the left hand axis, as the thin orange line.

The historic data is a set of annual estimates calculated by PIT for all countries in the database. This ratio is similar to IMF and OECD definitions for GDP Output Gaps. For comparability, exchange rates have been rebased to set year-end 1994 at 100.

Best Guesses show what would happen to the difference in the pressure of demand based on forecasts for spare capacity, both at home and abroad. Depending on whether the investment perspective is Dollar-based or relative to a global benchmark, the relevant foreign forecasts are those for the United States or a GDP weighted global average. PIT forecasts of each GDP output gap are in turn based on Consensus Forecasts for GDP.

Owing to the conversion of legacy currencies into Euros, analysis is provided on the common currency, rather than for individual countries. Historical data is provided by creating synthetic GDP-weighted time-series for the component currencies, expressed in the European Currency Unit.

This strategy is eventually self-correcting but may experience extreme swings before doing correcting, so it is of little value as a market timing indicator. It is more useful for warning of extreme risk.