The Australian dollar is overvalued, but that doesn't guarantee the RBA will talk it down today

Getty/Sandra Mu

The Australian dollar has risen sharply since mid-January, gaining around 12% against its US counterpart. The rapid increase has captured the imagination of financial markets, with speculation over what the RBA may or may not do to mitigate its recent strength hitting epic levels in recent days.

“Jawboning”, or talking the level of the currency down, has been widely speculated upon. Some have even floated the prospect of further rate cuts should the Aussie continue to gain.

To Joseph Capurso, senior currency strategist at the CBA, even with the recent rebound in commodity prices, the Aussie is currently overvalued on a trade weighted basis.

“Plugging in the latest information on commodity prices and the real interest rate differential yields an estimate of what the RBA model might say about valuation of the real TWI,” says Capurso. “Our replica of the RBA model suggests the real TWI is around 3% above the +/- one standard deviation band (6%) averaged over Q1. The last time the real TWI was as over-valued as it was in Q1 2016 was in Q3 2014. The RBA left the cash rate unchanged for all of 2014 but did cut the cash rate in early 2015.”

The chart below, supplied by the CBA, replicates the RBA’s Australian dollar real trade weighted index (TWI) model that can be used to determine the value of the currency based off commodity prices and interest rate differentials between Australia and its major trading partners.

The real TWI is the weighted average value of the Australian dollar in relation to the currencies of Australia’s nineteen largest trading partners, adjusted for changes in inflation.

Though the currency is overvalued on this metric, Capurso suggests that does not necessarily mean that the RBA will “jawbone” the currency in its April monetary policy statement.

“There is not a great correlation between over-valuation in the RBA’s model and rhetoric about the currency by the RBA Board in its post meeting statement,” says Capurso. “The bottom line is the RBA will use its judgement in describing whether or not the exchange rate is overvalued on 5 April.”

The table below, supplied by the CBA, reveals there’s no major relationship between the RBA’s commentary towards the currency and the level of the Australian dollar real trade weighted index.

In order to get a major reaction in the Aussie today, Capurso suggests the RBA will need to be more proactive in talking the exchange rate down.

“They could use the model results to indicate the exchange rate is unhelpful, overvalued, too high or ahead of itself,” says Capurso. “In our view, the AUD would fall at least 1% in reaction.”

On the other side of the ledger, if the RBA’s commentary towards the currency remains unchanged — indicating no great deal of concern towards its recent strength — it could act as a catalyst to spur on further gains.

In overnight trade the Aussie fell against most major currency pairs, dragged lower by weakness in commodity markets and caution before today’s RBA policy meeting. As at 7.30am in Sydney, the AUD/USD buys .7598, down 1% on Friday’s closing level.

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