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Australian Dollar is 10% Undervalued says CBA, but Closing the Gap Will be a Drawn Out Affair

 © Neal Jennings, Reproduced under CC licensing

- AUD 10% undervalued Vs USD after 2018-2019 falls says CBA.

- Fed hikes, RBA cuts and widening yield gap drive undervaluation.

- But the mismatch between prices and value will be slow to correct.

- AUD/USD to close half the gap by end 2020, GBP/AUD set to fall.

The Australian Dollar is undervalued by a double-digit percentage although correcting the mismatch between market prices and the intrinsic value of the Antipodean unit could be a long and drawn out process, according to new analysis from Commonwealth Bank of Australia.

Australia's currency is down almost 1% against the U.S. Dollar for 2019 and by 5.4% over the last 12 months, leaving it trading just beneath the 0.70 handle on Wednesday, although its "fair value" is actually 0.79. But Commonwealth, one of Australia's largest lenders, forecasts it will only recover a fraction of this value over the next 18 months.

"There are two main reasons AUD/USD is undervalued.  First, because the Australian current account deficit has narrowed to 0.6% of GDP compared to its thirty‑year average of 4.1% of GDP.  And second, because the RBA’s commodity price index (in $US) is at a five‑year high. However, the Australian‑US 3‑month interest rate spread is close to historical lows," says Kim Mundy, a strategist at CBA, in a note to clients Wednesday. 

The Australian Dollar has been dragged lower on the currency market by a range of factors in recent quarters, even as higher commodity prices and a narrowing current account deficit have lifted its fundamental value. 

Above: AUD/USD rate (orange line, left axis) follows AU-U.S. yield spread lower from January 2018.

Federal Reserve (Fed) interest rate policy saw U.S. borrowing costs rise more than 1% in 2018, with rates increasing from 1.5% to 2.5%, at a time when the Reserve Bank of Australia (RBA) cash rate remained steady at 1.5%.

That led yields on American government bonds to rise at a time when Australian yields were falling. As a result, the gap between U.S. and Australian yields, which once favoured the Aussie, turned negative and began to favour of the U.S. currency in January 2018.

Movements in the above yield differentials, or 'rate spreads', are determined largely by relative central bank interest rate policies and have a significant influence over international capital flows as well as exchange rates. 

Capital flows tend to move in the direction of the most advantageous or improving returns, with lower rates and yields normally driving investors out of and deterring them away from a currency. Rising rates and yields have the opposite effect.

The Fed is now expected to cut its interest rate twice before year-end but this might not necessarily bring relief to the Aussie, not least of all because the Reserve Bank of Australia has already cut its interest rate this month, to a new record low of 1.25%.

And financial markets are convinced that even further cuts are on the way in the very near future. The RBA cash rate for December 03, implied by the overnight-index-swap market on Wednesday, was just 0.74%. That suggests investors expect another two cuts in 2019, which is more than the Fed is seen delivering.

Above: CBA graph showing AUD/USD, Australian terms of trade and 3-year rate spread.

"The inputs for this model are: Australian commodity export prices (in $US), Australia‑US 3‑month interest rate spread, and Australia’s current account deficit (as a percentage of GDP)," says CBA's Mundy. "Our currency forecasts are not reliant on the above models, but we do take the inputs in each model into account when making our forecasts, along with other factors. It’s important to remember that exchange rates can deviate for lengthy periods of time from model‑based estimates of fair value." 

The RBA has cited below-target inflation and economic growth that is too soft to engineer a return of the consumer price index to the 2%-to-3% target as the reasons for its rate cuts. It's now watching the labour market closely for clues on what it needs to do next. 

RBA Governor Philip Lowe has said the jobs market is key to the outlook for consumer spending, the economy and its inflation target. The bank says wage growth in the region of 3% above the rate of inflation per year is necessary to get the consumer price index above 2%.

But that faster wage growth requires a lower unemployment rate, likely in the region of 4.5% according to the RBA, and the Aussie jobless figure has risen 30 basis points to 5.2% in recent months. Meanwhile, house prices and construction activity have continued to fall, stoking fears over jobs in the sector. 

House prices in Australia's eight capital cities have fallen steeply in the last 18 months, leading some to worry about the outlook for construction jobs as well as the possibility that negative 'wealth effects' hurt household confidence and reduce growth by crimping consumer spending. 

Above: CBA graph showing Australian unemployment rate Vs jobs growth.

The Australian Dollar has already paid for the RBA cuts that markets are betting on. But that still leaves U.S. interest rate policy as a big and unknown variable that could influence the gap between bond yields of the two countries.

CBA says Fed policy is a highly important factor behind its Australian Dollar forecasts. It projects the Australian Dollar will close around half of its undervaluation gap before the end of 2020, with the upturn beginning in December this year. 

"We believe a 25 basis point on 31 July is a virtual certainty. Powell and Bullard emphasised that the case for more accommodative policy has strengthened.  We also believe there will be follow‑up cuts in December 2019, March 2020 and June 2020. The Fed rate cuts will weigh on USD," Mundy says.

CBA forecasts the AUD/USD rate will rise to 0.72 by year-end and that it will finish the 2020 year up at 0.74. The Pound-to-Australian-Dollar rate is expected to fall from 1.8148 Wednesday to 1.7777 by year-end before declining to 1.7568 by time the curtain closes on 2020. 

"If the Fed begins an easing cycle in response to low inflation pressures, the USD is likely to depreciate. AUD/USD will subsequently lift into year-end, as negative Australia-U.S. interest rate differentials reverse direction and begin to narrow," writes Richard Grace, head of FX strategy, in a May forecast note. 

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