Market Insights: Fundamentals still favour a lower Australian Dollar

Fundamentals still favour a lower Australian Dollar
Despite higher interest rates in the United States and ongoing weakness in commodity prices, the Australian dollar has broadly trended sideways since late 2015. This note updates our model estimates of fair-value for the $A against the US dollar in light of recent interest rate developments and the December quarter terms of trade results. Although we find that the $A is now closer to fair value (based on current fundamentals), it still seems likely to eventually break below its recent range as fundamentals continue to evolve.

$A Range Bound As RBA Stays On Hold

As seen in the chart below, the $A’s decline flattened out somewhat over the latter part of 2015, with prices meeting consistent resistance at just under US70c.At the same time, the $A has also tried and failed to rally much beyond US73c, leaving the currency range bound. At around US71c, the $A is currently around the middle of recent range.

aud1

The range-bound nature of the $A has come despite ongoing declines in commodity prices. Indeed, the Reserve Bank’s Index of Bulk Commodity Prices (largely comprising spot coal and iron ore prices) declined by a further 20.6% in the second half of 2015, and by a further 2.7% in January alone.

Despite weaker commodity prices, the $A seems to have taken some heart from the resilience of the local labour market  – with the unemployment rate declining to below 6% – which in turn allowed the RBA to leave official interest rates comfortably on hold since May 2015.

$A Close to “Current” Fair Value

That said, it’s also true that the $A is less clearly overvalued than it used to be.  To assess fair-value, I’ve updated my fundamental $A model – which is largely based on the same methodology as the RBA – and covers both the terms of trade and inflation-adjusted interest rate differentials between Australia and the United States.  Previous model updates are provided here and here.

As seen in the chart below, largely reflecting the continued steady decline in the terms of trade, our estimate of ‘fair-value’ for the $A declined to around US70c in the December quarter of 2015, compared with US73c in the June quarter 2015 and US78c in the December quarter of 2014.

Amodel1 Notably, after some initial hesitancy in recent years – which left the $A up to 15% overvalued at times – the $A’s levelling out at around US71c means it is now more closely aligned with current fundamentals. That’s another reason why the RBA has seemed somewhat more comfortable with the $A’s level in recent months, and has not sought to “jawbone” its value lower.

David Bassanese is the Chief Economist for BetaShares. BetaShares is an Australian manager of funds which are traded on the Australian Securities Exchange. BetaShares offers a range of exchange traded funds which cover Australian and international equities, cash, currencies, commodities and alternative strategies. Author website: www.betashares.com.au/insights/author/david-bassanese
This post was originally published at the BetaShares Blog at www.betasharesblog.com.au/market-insights-fundamentals-still-favour-a-lower-australian-dollar

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