Following the Reserve Bank of Australia’s decision to cut interest rates last month, ongoing weakness in commodity prices, and heightened expectations that the United States Federal Reserve will raise interest rates within coming months, it’s no surprise the Australian dollar has taken a tumble of late. Indeed, after a slight firming trend following the February RBA rate cut, the $A has declined by around 3.6% in recent weeks to reach US76c. The trade weighted index exchange rate (TWI) has declined by a somewhat smaller 2% over the same period.
Our analysis – based on valuation models similar to those of the RBA – now suggests the Australian dollar is no longer overvalued (using traditional criteria) compared to the US dollar.
On a TWI basis, the $A is only 2% overvalued at current levels. This is consistent with recent RBA research (released under a Freedom of Information request), which estimated the real TWI was “little less than 2% above the level consistent with its medium-term determinants in Q1 2015 to date.”
$A should fall further
Does this mean the $A should not fall any further? Not in our view. Indeed, our $A valuation model is based on relative real interest rate differentials between Australia and major trading partners, together with the terms of trade.
In this regard, we expect interest rate differentials to narrow further, dragging down fair-value for the $A. Our long-held view has been that the United States economy would remain strong this year, forcing the Federal reserve into raising US interest rates by mid-year. The US Federal Funds rate could easily reach 1% p.a. by year end. At the same time, we expect persistent weakness in the Australian economy to lead the RBA into cutting official interest rates to 1.5% p.a. this year.
As a result, the current nominal and real interest rate differential between Australia and the US could narrow by around a further 1.75 percentage points this year.
Meanwhile, iron ore prices continue to tumble, with the benchmark spot price dropping to a six-year low of $US57.70 a tonne. Our estimates suggest the terms of trade could fall by around 3% in the March quarter, and (based on current iron ore pricing) a further 5% in the June quarter.
These interest rate and terms of trade movements alone would drop our estimate of $A fair-value to around US71c. If commodity prices fell further, and the US continued to raise interest rates in 2016, our fair-value estimate would drop even further.
RBA Shifts tone
What’s more, in a subtle but important recent change in tone, the RBA now appears to be arguing that the $A should ideally drop below traditional fair-value estimates due to the post-mining boom challenges facing the economy. In the FOI release noted above, the RBA’s research department argued that “even though the current value of the AUD appears to be largely ‘explained’ by the baseline model, it could still be considered to be ‘overvalued’ to the extent that it is judged to be too high to achieve desired domestic economic outcomes.”
This was echoed by Assistant RBA Governor Christopher Kent in a speech this week, where he argued “while the depreciation seen to date will be helpful, our assessment is that our exchange rate remains relatively high given the state of our overall economy.” This suggests the RBA could continue to actively “jawbone” the $A lower even if valuations now remain broadly in line with traditional fundamentals.
All up, our view remains that the $A will decline to around US68c by year-end.
Investment Implications – consider offshore exposure
Likely further weakness in the $A – which in turn reflects relatively sluggish local economic growth – suggests investors might contemplate some offshore exposure to diversify their risks. Indeed, by merely increasing exposure to foreign currencies that rise in value against the Australian dollar, local investors may be able to generate positive returns via the exchange rate without necessarily having to take on foreign market equity, commodity or fixed income risks.
One such product that easily provides such exposure is the BetaShares US Dollar ETF (ASX:USD). The product simply holds US$ as its underlying asset – thereby providing direct exposure to movements in the A$/US$ exchange rate, and rising in value as the $A declines against the US$ (conversely, the Fund will go down if the $A goes up against the US$). The Fund offers this exposure at a much cheaper cost than using a traditional foreign currency bank account (for a comparison see here.) Betashares also offers two other currency ETFs providing exposure to the Euro and British Pound.
For those investors seeking offshore unhedged equity market exposure, moreover, BetaShares, currently offers two products providing exposure to the US equity market – the FTSE RAFI U.S. 1000 ETF (ASX:QUS), and the S&P 500 Yield Maximiser Fund (managed fund) (ASX: UMAX). The links provide further information on these Funds.
 An index of movements in the Australian dollar against the currencies of major trading partners, weighted by the latter’s importance to Australian international trade.
 Nominal interest rates less annual core inflation.
 Ratio of Australia’s export price index to the import price index.
 “Australian Economic Growth –The How, What and Where”. Address to the National RSL Clubs Conference Hobart, 11 March 2015.