Australian Dollar Predictions: CBA says Outlook now More Evenly Balanced

- AUD upside risks building says CBA
- Comes after months of weakness
- U.S. & Chinese economies pip domestic concerns

Australian Dollar

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The outlook for the Australian Dollar has improved and upside risks are starting to build, according to a new research update from Commonwealth Bank of Australia that cites the importance of developments in China and the U.S. over domestic concerns.

The lender says the Australian Dollar is also likely to find itself better supported by its chronic undervaluation when fundamentals are considered.

"Downside risks are still there. All that has changed is that an upside risk has emerged," says Joseph Capurso, Head of International Economics at CBA.

Indications that the U.S. Federal Reserve will wait to announce its intention to taper asset purchases appears to be the most important supportive development concerning the currency of late.

Indeed, Australia might still be grappling a Covid outbreak that has seen the majority of its population placed under some for of restriction but the Australian Dollar has steadily recovered from its August lows:

The Australian Dollar-to-U.S. Dollar exchange rate has risen from an August 20 low of 0.7105 back to 0.7430 where it is found at the time of publication.

The Pound-to-Australian Dollar exchange rate has fallen from a high of 1.9154 on August 20 to 1.8629 today.

Australian Dollar exchange rates

Above: GBP/AUD top and USD/AUD bottom. This serves to show the centrality of the USD leg to GBP/AUD.

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That August 20 was a turning point is significant as it was at on this date that the broader Dollar index - a measure of overall USD strength - peaked.

Accordingly the lows in GBP/USD and EUR/USD were also hit on this date, serving as a reminder of just how central the U.S. Dollar is to broader FX moves.

And the Dollar is in turn primarily reacting to U.S. economic data as it pertains to U.S. Fed policy: weaker data has come in over recent weeks that suggests the need for the Fed to reduce its quantitative easing programme (taper asset purchases) has declined.

This is a signal to the market that the Dollar's run higher might have ended for now, and the Australian Dollar could prove to be a prime beneficiary.

"One of the most useful gauges of AUD/USD is simply the USD index. AUD/USD can simply trade as a mirror image of the USD index. The strong inverse relationship illustrates the importance of the USD leg of AUD/USD. It also highlights the dominance of news and views about the US economy," says Capurso.

The U.S. economic rebound story has suffered a setback amidst rising Covid-19 cases, driven by the Delta variant.

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This has in turn hit consumer and business confidence, sparking a slowdown in economic output and hiring; an outcome most recently confirmed by the release last Friday of the August job report which underwhelmed.

"We consider the setback in the labour market and the jump in serious infections will encourage the FOMC to wait before it announces it will taper its monthly asset purchases," says Capurso.

CBA now anticipate the Fed to announce a taper of its monthly asset purchases at its November 03 meeting instead of the previously assumed September 22 meeting.

"The delay to tapering has weighed on the USD and supported AUD/USD in our view," says Capurso.

The dominance of AUD/USD has meant other Australian Dollar exchange rates have responded accordingly; therefore should AUD/USD continue to recover then expect GBP/AUD and EUR/AUD to fall.

CBA analysis meanwhile finds the Aussie Dollar to be undervalued relative to economic fundamentals, a view that is a common one amongst a number of investment banks and research houses we follow.

AUD fair value

Above: CBA's fair value estimates show the Aussie to be undervalued relative to fundamentals.

"AUD is seriously undervalued compared to its fundamentals of commodity prices and interest rate differentials. An important part of our currency forecasts is AUD will close the gap with valuation in 2022," says Capurso.

CBA says that the Aussie Dollar's outlook now looks more balanced than during the mid-year period where they saw downside risks as being dominant.

Downside risks still exist, but they emphasise upside risks have since emerged.

These downside risks include ongoing weakness in the Chinese economy where growth rates have slowed sharply over recent months.

A slowing Chinese economy spells waning demand for Australia's commodity exports, a key source of support for the currency.

Chinese economic growth projections

Above: CBA's Chinese GDP projections are lowered.

Analysts are also concerned that a shifting policy stance by Chinese authorities - one that is focussed on the Chinese consumer and not infrastructure - won't benefit mining commodities.

Falling Australian bond yields are another risk which stems from 'dovish' Reserve Bank of Australia (RBA) policy.

Aussie interest rates are at record lows and there is speculation that the RBA will delay its own asset purchase tapering until 2022 in light of the sharp slowdown in Australian economic activity.

But, "the prospects for the spread dropping down towards ‑25bp (the previous short‑term target) have faded as the Australian vaccination rates have risen more quickly than anticipated thanks to extra vaccine doses and something resembling optimism has returned to the bond market," says Capurso.

Given all of the above, CBA anticipate the AUD/USD will trade a range of 0.70 to 0.77 before the end of the year.

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