aud fundamentals

Australian Dollar/US Dollar Exchange Rate Forecast

Monday, 22 December 2008 20:20:59 GMT  |  Jamie Saettele, Senior Strategist; David Rodriguez, Quantitative Analyst; Ilya Spivak, Currency Analyst

Australian Dollar/US Dollar Long-Term Exchange Rate Technical Forecast

As was expected, the 5 wave drop from the top (.9856) has given way to a larger correction. The 3 wave rally from .60 may be just the first of a string of 3 wave moves that will form wave (2) within the long term decline that began at .9856. A choppy range may form as a B wave drifts lower from here.

Australian Dollar/US Dollar Exchange Rate Interest Rate Forecast

The Australian Dollar - US Dollar interest rate differential is forecast to narrow substantially in the coming 12 months-adding further pressure on the previously high-flying Australian Dollar. Forex speculators had previously sent the AUD to multi-decade highs against its US namesake, as a strong interest rate advantage proved irresistible to highly leveraged investors. Yet the more recent wave of financial market deleveraging forced many traders to close long positions in the Australian Dollar and cover short positions in the comparatively low-yielding US Dollar. This dynamic explains the sometimes-violent declines in the AUD/USD during times of elevated financial market stress, and we expect said effects to continue driving Australian Dollar price action through the foreseeable future.

Interest rate traders predict that the Australian Dollar/US Dollar yield differential will fall by a further 98 basis points in the year ahead-a further bearish development for the Aussie dollar. If current financial market turmoil continues, we may see the previously high-flying Australian currency fall against its US counterpart.

Australian Dollar/US Dollar Exchange Rate Valuation Forecast

Australian Dollar/US Dollar Valuation Forecast: Neutral

The deep selloff that had seen the Australian Dollar punished along with other risky assets saw the pair overshoot the PPP level, making the Aussie temporarily undervalued against the US dollar. The pair has since corrected higher, now standing within a hair of its "fair" exchange rate. While AUD scored gains in December, these were modest compared to the likes of the Swiss Franc and the Euro, suggesting tepid buying interest. Further favoring the bears, the specter of further rate cuts continues to hang over AUDUSD, with traders pricing in large additional rate cuts from the RBA over the next 12 months. While these considerations strongly suggest a period of undervaluation ahead, a purely valuation-based approach would favor looking at pairs showing more glaring deviations from PPP.

What is Purchasing Power Parity?

One of the oldest and most basic fundamental approaches to determining the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. For example, if a pencil costs €1 in Europe and $1.20 in the US, the “fair” EURUSD exchange rate should be 1.20. For our purposes, we will use the PPP values provided annually by the Organization for Economic Cooperation and Development (OECD). We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar. Currencies overvalued against the Dollar are denoted in RED, while those that are undervalued are denoted in GREEN.

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