Australian Dollar's Fair Value has Fallen Sharply: CBA

"Iron ore spot prices have fallen by over 33% from in the record high in mid-May. The fall in prices has pulled lower our estimate of AUD/USD fair value" - CBA.

Iron ore prices and impact on the Australian Dollar

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The Australian Dollar's fair value has fallen notably over recent weeks says Commonwealth Bank of Australia, reinforcing a view that the currency is liable to maintain its current trend of depreciation.

"AUD can build on its downward momentum and temporarily dip below 0.7000," says Carol Kong, Associate International Economist and Currency Strategist with Commonwealth Bank of Australia (CBA).

The Australian Dollar has fallen for five days in succession against both the U.S. Dollar and British Pound, a move that is heavily influenced by a broader deterioration in investor sentiment.

Australian Dollar vs. the Pound and U.S. Dollar

Above: AUD/USD top, GBP/AUD bottom.

The Pound-to-Australian Dollar exchange rate has risen 1.75% this week alone, its largest weekly advance recorded since September 2020, taking it to spot levels at 1.9137. Crucially, for those transferring money the retail rate on offer at leading currency specialists is now at the 1.90 level.

The Australian-to-US Dollar exchange rate has meanwhile succumbed to a more substantial 3.40% loss to 0.7117, this is again its largest weekly decline since September 2020.

Until global investors find their confidence again, and the domestic Covid situation in Australia stabilises, it is hard to see the Australian Dollar staging a material comeback.

The source of the deteriorating external sentiment appears to be China, where growth is coming off the boil amidst a combination of rising Covid cases and government crackdowns on the technology sector and segments of the economy deemed in breach of environmental standards.

The environmental crackdown has notable implications for the global commodity sector, of which the Australian economy is heavily reliant.

Nikkei reports China's oil imports are plunging as Beijing cuts supplies to dirty local oil refineries. Oil shipments to the world's largest crude importer fell 20% in both June and July, year-on year, mainly because the government is reducing import quotas for independent refineries that fail to meet environmental standards.

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China's crude oil imports for January to July fell 5.6% on the year to 301.83 million tons, according to customs authorities.

The decline has accelerated in the past few months.

Meanwhile, and more importantly for Australia, iron ore prices are also on the move lower.

"Iron ore spot prices have fallen by over 33% from in the record high in mid-May. The fall in prices has pulled lower our estimate of AUD/USD fair value," says Kong.

Kong says concerns about China’s steel production have pushed iron ore prices down by one quarter so far this month.

"Iron ore is Australia’s top export and has the greatest weight in the RBA’s monthly commodity price index. Based on our estimation, the month-to-date fall in iron ore and other commodity prices would result in a 10% fall in the RBA commodity price index in August," says Kong.

CBA fair value model

Commodity prices are therefore understandably the major driver of CBA's AUD/USD fair value equation.

"The fall in commodity prices has pushed down the mid-point of AUD/USD fair value range from 0.88 to 0.84 so far in August. It is the first time since November 2008 fair value has decreased by 4 US cents in a single month," says Kong.

Nevertheless, despite a decrease in fair value, CBA observe the AUD/USD exchange rate to be materially undervalued relative to its fundamentals because of the recent fall in AUD/USD spot.

We have noted at various points in 2021 this undervaluation is linked to the low interest rates on offer in Australia, courtesy of the Reserve Bank of Australia's policies to support the economy.

In previous episodes of high commodity prices the Australian Dollar has strengthened notably, particularly in the early 2010's.

Back then high commodity prices were consistent with a booming Australian economy that commanded interest rates that were far superior to those on offer in other major economies.

This in turn attract vast flows of international capital that elevated the Australian Dollar.

But in the current cycle of hot commodity prices Australia's interest rates are materially lower and are of little interest for yield-hunting investors.

This situation is unlikely to change given the ongoing Covid crisis in Australia which will likely keep the RBA coy on pursuing interest rates for some years, suggesting the Australian Dollar can remain undervalued relative to commodity prices for an extended period.

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