- The Australian dollar hasn’t been this cheap since the GFC, according to the Commonwealth Bank’s fair value model.
- The significant discount largely reflects fears over the US-China trade war.
- A senior strategist at the bank says markets are overestimating the trade war’s impact on the global economy.
- Outside of a trade resolution, the CBA says there are three potential triggers that could see the Aussie strengthen.
The Australian dollar hasn’t been this undervalued against the greenback since the depths of the global financial crisis, with fears over a potential escalation in the US-China trade conflict largely to blame.
According to Joseph Capurso, Senior Currency Strategist at the Commonwealth Bank, the AUD/USD is now extremely cheap based on the bank’s fair value model.
The model’s inputs include commodity prices priced in US dollars, the three-month interest rate spread between Australia and the US, and Australia’s current account deficit as a percent of Australian nominal GDP,” he says.
“Using this equation, we find the AUD/USD is currently undervalued by around 11%. It has not been undervalued by this much since the height of the global financial crisis in 2008/09.”
Here’s the Commonwealth’s fair value model compared to actual movements in the currency.
Capurso says some of the undervaluation may reflect that the model is not taking into account broad-based US dollar strength, although he suspects that much of it stems from a large discount being applied due to concerns about the trade conflict between the US and China escalating.
“The undervaluation… may suggest that markets are placing too much weight on the trade frictions,” he says.
In his opinion, markets have overreacted to the trade conflict, overestimating just how great an impact it will have on the global economy.
“Out long held view is trade frictions will have a small long-term impact on the US, Chinese and Australian economies,” Capurso says, adding that “not enough weight is being put on the fundamental drivers” of the Aussie.
While uncertainty about the outlook for trade negotiations remains heightened, ensuring the AUD/USD continues to trade at a significant discount compared to fundamentals, Capurso says there are some other factors that could see this discount narrow even without a lasting trade agreement.
“A potential near-term trigger for a stronger AUD/USD is if the FOMC indicate a pause in its rate hiking cycle at its December 19 meeting, generating a softening of the US dollar,” he says.
“Another potential requirement is a lift in European economic growth, and in turn global economic growth, to encourage an appreciation in the Aussie.”
Domestically, Capurso says another soft Australian GDP report for the December quarter cannot be repeated.
“We would probably also require a return to stronger Australian GDP growth in Q4, accompanied by some wage and inflationary pressures, to lift Australian bond yields relative to those in the US.