This chart says the Australian dollar isn't overvalued because commodity prices are higher

William West/AFP/Getty Images

The Australian dollar is on the charge, rising above the 80 US cent level for the first time since May 2015 on Wednesday.

On a trade-weighted basis it’s also at its highest level since December 2014.

For a central bank that has been warning for some time that appreciating exchange rates would “complicate” Australia’s economic transition, its recent strength is seemingly creating a headache for the Reserve Bank of Australia (RBA), increasing the odds that the bank may attempt to talk it – “jawbone it” –
lower, in the minds of many analysts.

But is the Aussie really that overvalued?

Yes, interest rate differentials between Australia and other nations have narrowed sharply in recent years, something that would normally act to weaken the Aussie, but commodity prices are rallying hard and the global economy is strengthening, two factors that have, in the past, worked in the Aussie’s favour.

It creates a conundrum.

Is the Aussie unjustifiably high or is it about where it should be given the favourable global backdrop?

To Joseph Capurso, senior currency strategist at the Commonwealth Bank, the answer to that question is no, the currency is not significantly overvalued based on his Australian dollar real trade-weighted index model (TWI), and that suggests the RBA is unlikely to be overly concerned at its current level.

The real TWI adjusts movements in the Australian dollar against changes in inflation in Australia’s major trading partners.

Here’s how the Commonwealth Bank’s AUD real TWI model compares to that produced by the RBA.

Source: Commonwealth Bank

“Plugging in the latest information on commodity prices and the real interest rate differential generates an estimate of what the RBA’s model might say about the valuation of the real TWI,” says Capurso.

“Our replica of the RBA model suggests the real TWI was just 1.8% below fair value in Q2, and was just 1.6% above fair value in Q3.”

So not all that overvalued based on the Commonwealth Bank’s modelling.

Capurso says higher commodity prices largely explain why the Aussie still remains around fair value, pointing out that it’s the dominant influence in the RBA’s own modelling, accounting for about two-thirds of variation in the real TWI.

Real interest rate differentials, in comparison, account for only around a third of the movement in the real TWI index.

“We find the current level of commodity prices largely supports the current value of the currency,” says Capurso.

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