The Aussie dollar has been in a broad downtrend since September, having lost around 6% after reaching a 2017 high above US80 cents.
And recently, currency markets have been focused on the declining yield spread between US and Australian government bonds.
Yields on US 2-year bonds have risen above the yield on Aussie 2-years for the first time since 2000 as bond markets react to near-term interest rate expectations.
As the spread between Aussie and US bond rates narrows, the currency is less attractive for investors looking to profit from the interest rate differential.
But according to ANZ currency strategists Daniel Been and Nathanael Hartley, the recent focus on yield spreads has been overdone.
“The narrowing of the rates spread between Australia and the US has captured the market’s attention and on a short term basis has become the only driver in the market,” the pair said.
“The laser-like focus on spreads has meant that the evolution of other (and on average equally important) drivers has been ignored, leaving the market vulnerable to a reversion to some of these trends.”
They highlighted iron ore as another key driver that’s having less of an impact while rates are the current “flavour of the month”.
As Australia’s largest export, the currency typically benefits when iron ore strengthens — and although prices are volatility, the recent iron ore bull market has seen prices climb to a three-month high.
Been and Hartley said that on a medium-term basis, the Aussie is actually one of the few major currencies for which medium-term pricing models have proved to be consistently accurate.
“We know, with a high degree of confidence, that the AUD is determined by a combination of the level of the terms of trade (primarily driven by export prices), interest rate differentials and global beta (volatility),” they said.
To illustrate their point, the two analysts argued that if the AUD was modelled exclusively against the yield spread, it could fall back into the mid-US60 cents range.
But isolated against commodity prices, ANZ’s model suggests a fair value of around US85 cents.
And importantly, both rate spreads and commodity prices have a similar fit to the model on a five-year basis, so it doesn’t make sense for the market to preference one over the other.
“This is why we think that, when all the factors that usually influence the AUD are taken into account, sentiment towards the AUD remains too bearish in the near term,” the analysts said.
The AUD has found support in midday trade after retail sales data beat expectations this morning, and a short time ago was up by around 0.5% in Asian trade at 0.7638 US cents.
Amid a big day of Australian data releases, currency traders will now shift their attention to the RBA’s monthly interest rate announcement at 2:30pm AEDT.