UBS: This model suggests the Aussie dollar is overvalued by around 5%

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Even after its recent fall, the Australian dollar is still overvalued by around 5%.

So says Scott Haslem, an economist at UBS, who points to the chart below to justify his call. It’s a replica of the Reserve Bank of Australia’s (RBA) Australian dollar fair value model, with the Aussie currently at the upper end of its fair valuation range.

“While not outside the fair value range, as it was in late 2012 or mid-14 – periods when RBA Governor Stevens referred to the AUD as ‘quite high’ relative to commodity prices, ‘overvalued, and not by just a few cents’ – the rising AUD remains a ‘complication’ for the RBA that presents some downside risk for the otherwise ongoing rebalancing of the economy,” says Haslem.

Although higher commodity prices have contributed to the Aussie’s recent rally in his opinion, Haslem suggests that capital inflows into Australian bonds, still an attractive source of yield for offshore investors, has been the main factor that has driven the currency to it current “overvalued” level.

“While Australia’s higher commodity prices are supporting the AUD, it is likely that strong flows into AUD bonds are the key source of ‘over-valuation’, as was the case for a sustained period through the European sovereign bond crisis in 2013,” he says.

UBS, like others, suggests that the Aussie will fall over the next nine months, undermined by the prospect of higher US interest rates, weaker commodity prices and a likely slowdown in the Chinese economy.

Here’s Haslem on what to expect:

By end 2016, our US economists expect the Fed to have lifted the funds rate by a further 25bp (with two more hikes in 2017), our China team expect renewed evidence of slower China growth post the stimulus earlier this year (with growth slipping to 6.3% in 2017 from 6.7% today), while our commodities team expect the iron ore price to slip back toward US$50 (a ~20% fall from today’s US$61/tn price).

Reflecting this, we continue to see the AUD lower at USD0.70 by mid-17, albeit our end-16 forecast for the same, now just a few months away, looks a few cents challenged to the high side, given the likelihood of ongoing strong bond flows and a (overly) cautious US FOMC.

The AUD/USD currently buys .7535.

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