One of the more common phrases thrown around in FX markets is that a currency looks “cheap” or “expensive.”
At face value, that sounds straightforward enough.
But once you dig into how currency valuation actually works, things become a lot more complicated.
Because unlike equities or bonds, currencies don’t produce cashflows. There’s no earnings multiple. No dividend yield. No clean intrinsic value model sitting underneath the market.
Instead, FX valuation is more about estimating where a currency should trade relative to broader economic conditions – and understanding why markets may temporarily diverge from that level for extended periods of time.
That’s where frameworks like Purchasing Power Parity (PPP) come in.
The problem is that many traders treat PPP as though it’s some kind of definitive fair value model when, in reality, it’s only one small piece of a much bigger puzzle.
What is Purchasing Power Parity (PPP)?
At its core, PPP is based on a relatively simple idea:
Currencies should eventually adjust so that identical goods cost roughly the same across countries over time.
If inflation rises faster in one country than another, its currency should theoretically weaken over the long run to maintain relative purchasing power.
Simplified versions of PPP are often represented as:
S=P2P1
Where:
- S = exchange rate,
- P1 = domestic price level,
- P2 = foreign price level.
In theory, if prices rise faster in one economy, the exchange rate should gradually adjust to compensate.
That’s the academic logic behind it.
And over very long periods, PPP can actually be surprisingly useful as a broad anchor for identifying currencies that may look structurally rich or cheap.
But FX markets don’t trade in theory alone.
The problem with using PPP in isolation
The biggest issue with PPP is timing.
Currencies can remain significantly overvalued or undervalued relative to PPP estimates for years at a time.
Sometimes even decades.
That’s because FX markets are influenced by far more than relative price levels alone.
For example:
- capital flows matter,
- interest rate differentials matter,
- growth expectations matter,
- geopolitical risk matters,
- productivity trends matter,
- and market positioning matters.
A currency may appear “expensive” on PPP metrics while still continuing to strengthen because global investors are aggressively allocating capital into that economy.
Likewise, a currency can remain “cheap” for a very long time if markets lack confidence in the broader macro backdrop.
This is one reason why valuation models frustrate traders so often.
Being fundamentally undervalued does not automatically mean a currency is about to rally.
Why the U.S. dollar often looks “too expensive”
The U.S. dollar is probably the best modern example of PPP limitations.
For years, various valuation models have suggested the USD looked expensive against many major currencies.
And yet the dollar continued to remain structurally strong through large parts of the post-pandemic cycle.
Why?
Because markets weren’t simply pricing relative inflation.
They were pricing:
- higher U.S. real yields,
- stronger growth,
- global demand for USD liquidity,
- safe-haven demand,
- and persistent capital inflows into U.S. assets.
Those forces overwhelmed traditional valuation frameworks for extended periods.
That doesn’t mean PPP was “wrong.”
It simply means valuation alone rarely determines short or medium-term market direction.
Valuation works better as a framework than a signal
This is where many macro investors approach the concept differently from shorter-term traders.
Rather than treating valuation as a direct trading trigger, it’s often more useful as:
- a positioning framework,
- a long-term anchor,
- or a way of identifying asymmetry.
For example, if:
- a currency looks historically cheap,
- positioning is extremely bearish,
- and macro conditions begin improving,
that combination can become much more interesting than valuation alone.
Likewise, currencies trading far above long-term valuation ranges may become increasingly vulnerable if macro conditions start deteriorating.
In other words:
valuation tends to matter most when other macro forces begin aligning with it.
Why relative growth and capital flows matter so much
One of the biggest drivers missing from simplistic valuation discussions is capital allocation.
Global investors constantly move money toward economies offering:
- stronger returns,
- better growth,
- deeper capital markets,
- and more attractive risk-adjusted opportunities.
That flow of capital can sustain valuation dislocations for long periods.
Australia during commodity booms.
The U.S. during periods of elevated real yields.
Japan during decades of ultra-low inflation and structurally low yields.
These dynamics often matter far more to FX markets than whether a currency screens as “fairly valued” on an academic model.
Markets can stay irrational longer than expected
This is probably the most important point.
FX markets are not mechanical valuation machines.
They’re highly emotional, forward-looking and heavily influenced by positioning, sentiment and liquidity.
Currencies regularly overshoot.
Sometimes dramatically.
That’s why traders who rely exclusively on valuation models often end up fighting trends far too early.
A currency can absolutely become overvalued.
But markets frequently remain overvalued longer than logic initially suggests.
Final thoughts
Currency valuation matters.
But it matters in a much more nuanced way than many traders assume.
PPP can provide a useful long-term reference point for understanding whether a currency looks historically rich or cheap relative to inflation-adjusted price levels.
The mistake is assuming that valuation alone drives markets.
In reality, currencies are constantly being pulled around by:
- capital flows,
- interest rate expectations,
- growth differentials,
- risk sentiment,
- and broader macroeconomic regimes.
That’s why some of the strongest currency trends occur while valuation models are screaming the exact opposite.
Markets don’t move on valuation alone.
And honestly, they never really have.
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