The Australian Dollar’s impressive rally over recent months makes it one of the best-performing G10 majors with only the Euro and Swedish Krona outperforming in 2017.
The rally does however now leave it looking it uncomfortably placed from a valuation perspective with one noted Australian analyst suggesting “the recent rally in the AUD has pushed it above fundamental fair value.”
The call by Daniel Been, Head of FX Research at ANZ comes on the same day the Reserve Bank of Australia releases its Statements on Monetary Policy (SOMP) in which concerns over the currency’s value were expressed.
While the RBA was upbeat on the Australian economy’s outlook, the Australian Dollar was seen as being a point of concern.
However, this was by no means a hard stab at the Aussie Dollar by the RBA - indeed, they too might see the prospect of a sustained uptrend as being relatively limited.
“We do not expect that fundamentals can push it any higher and think that global risk appetite now looks extended,” says Been, “the AUD is due for some consolidation.”
The view is quite widely held in the analyst community with the team at Oxford Economics - the independent research organisation - suggesting the currency is expected to depreciate by around 3.5% over the rest of 2017.
Reasons Why the Australian Dollar Might Not Go Higher
1) Commodity Prices
Australia’s extensive endowment and production of raw materials such as coal, iron ore and natural gas mean movements in the Australian dollar are closely linked to global commodity prices.
Oxford Economics reckon coal and iron ore prices are now falling after recent highs, driven down by slowing demand growth in China.
“Moving into 2018, rate rises by the Fed will push the currency down further, to around AUD1.36 per USD,” say analysts at Oxford Economics.
ANZ Research continues to expect that iron ore will trade in a USD60–80 range. The sharp supply response that we saw from Chinese iron ore mines early in 2017 as prices spiked above this level suggests that global excess supply will keep a lid on prices.
2) Momentum Looking Stretched
The AUD has seen a strong rise over the past couple of weeks as a brief reassessment of the RBA’s bias (which has since been largely unwound) and an increasingly weak USD both took their toll.
“We think that this move is increasingly looking overdone. While this fact is easily verified by looking at technical momentum indicators, we have found additional evidence of the lack of sustainability in a number of our proprietary indicators as well,” says ANZ’s Been.
Kathy Lien, Director at BK Asset Management argues that the Dollar is actually where AUD's fortunes will be decided:
“2017 has been defined by strong exaggerated moves in many major currencies and after months of relentless uptrends, we are finally beginning to see signs of a top. Lower highs and lower lows or consolidation followed by rejection of key levels for currency pairs like GBP/USD, AUD/USD and USD/CAD has many investors wondering if deeper corrections lie ahead."
So if the Dollar starts to look oversold and begins a recovery, then the Aussie could come under pressure. Indeed, the currency's reaction to the August US jobs report would suggest that the prospect of a recovery is alive.
"We have to recognise that U.S. dollar weakness is the primary reason why the euro and Australian dollar are up more than 10% year to date,” says Lien.
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3) Economy Running Below Trend
Although strong in absolute terms, GDP growth is below trend with the economy still adjusting to the end of the mining boom.
“We expect the RBA to hold rates at 1.5% until 2020,” say Oxford Economics.
4) Overshooting Fundamentals
ANZ note the recent move has largely corrected the under-valuation that was evident for much of 2017.
This correction now looks like it is overshooting - but the message here is if the Aussie can recover from undervaluation, it can also do so from overvaluation.
Of course currencies can stay over- and undervalued for long periods of time.
“Since early 2015, the AUD has spent the majority of its time trading on the weaker side of fundamental fair value,” notes Been, “the recent move higher has reversed that.”
ANZ’s models show AUD is now four cents richer than its long-term relationship with rate differentials and commodity prices would suggest.”
5) Positive Global Risk Environment has Been ‘Absorbed’
The Aussie tends to like positive market conditions and ANZ observed at the start of 2017 that the currency’s value wasn’t accounting for the upbeat tone on global markets.
Their studies suggest this premium has now been absorbed by the currency, suggesting it can no longer be a positive driver unless global risk appetite rises materially.
“This is important – it means that there is no longer any cushion in the AUD,” says Been.
With the Aussie looking fundamentally fair-valued, what does this mean for the market?
Anticipating some retracement, ANZ have recommend buying a 1 month AUD/USD put spread, with strikes at USD0.78/0.76, for a cost of 44 AUD pips.
They also recommend selling AUD/CNH at 5.3535 with a target of 5.20. We will reassess this trade at 5.40.
From a Pound to Australian Dollar perspective, we won’t draw the conclusion that Sterling can now recover.
Far from it, it just take a half-decent currency to rally against the embattled Pound these days.
We would only be confidence in saying that these assumptions on the Aussie suggest the floor in GBP/AUD at ~1.60 that really has supported Sterling in the past will likely hold.
To go below here we would need a significant failure in investor confidence in Sterling, or a major rerating of Australian Dollar value which doesn’t appear likely.