The Australian dollar has endured a rollercoaster ride in recent months along with the significant volatility in global risk sentiment. After reviewing a range of fundamental drivers, however, it appears the $A is currently reasonably close to fair value.
An $A valuation framework
A lot has happened since I formally reviewed my $A valuation framework in November last year. At the time, I suggested the $A could fall to US62c (from US68c) by end-2020, reflecting a further narrowing in Australian-US interest rate differentials, weaker iron-ore prices and likely further strength in the $US due to the relative strength in the U.S. economy and equity market.
Obviously a lot has changed with the onset of the COVID-19 crisis! The $A in fact collapsed to US57c during the worst of the crisis on 19 March (a few days before global equity markets botttomed) and has since appreciated back to US71c.
So is the $A cheap or expensive, and what’s the outlook?
Terms of trade still high
At US71c, the $A is modestly above its long-run average real level of around US67c since the mid-1980s (deflating by respective inflation levels between Australia and the U.S. over this period). As evident in the chart below, that’s broadly consistent with the continued relatively high level of the terms of trade – which in turn largely reflects still relatively high iron-ore prices. Indeed, based on terms of trade trends alone, the $A arguably should be closer to US80c than US70c.
The $A has in fact experienced a trend decline since early 2018 despite continued improvement in export prices.
Interest rates and the $US countervailing factors
Two other factors that have generally worked against $A strength since early 2018 have been interest rates and the $US. As evident in the first chart below, the real short-term interest rate differential between Australia and the U.S. has tended to narrow over this period (reflecting Fed rate hikes and RBA rate cuts), though the differential has re-widened somewhat since the COVID-19 crisis.
As evident in the second chart, moreover, the $US has tended to remain firm over this period, though it has weakened a little of late due to the return of ‘risk-on’ sentiment.
$A appears close to fair value
My updated $A valuation model brings all these factors together as is detailed in the chart below. As evident, using a traditional valuation model based on interest rate differentials and the terms of trade alone (similar to the traditional RBA approach), the $A appears undervalued and should be trading just above US80c.
But factoring in trends in the $US dollar against all other global currencies (which actually produces a better-fitting model over time), the $A is actually now quite close to a fair-value estimate of around US69c. In short, despite ongoing strength in iron-ore prices in recent years, the narrowing in interest rate differentials and the global strength in the $US helps explain why the $A still tended to trend downward.
Where to from here?
Over the short term, interest rate differentials should remain a neutral influence (monetary policy cycles are aligned as both the RBA and the Fed will keep rates close to zero), while iron-ore prices should come back somewhat once current COVID-related disruptions to Brazilian supply are resolved.
That leaves the $US – which in my view remains likely to strengthen again if and when equity markets eventually pull back due to weak corporate earnings and a U-shaped global economic recovery. What’s more, given the likely ongoing relative strength of the U.S. economy and the U.S.-centric global technology sector even once the COVID-crisis is resolved, the $US may well remain stubbornly strong over the medium-term, which should also cap gains in the $A.