February 23, 2015

Australian Markets Weekly: AUD valuation metrics – what’s fair?

The RBA may be right to suggest that a lower AUD would promote more balanced growth, but its claim that the AUD remains overvalued rings hollow.

The RBA may be right to suggest that a lower AUD would promote more balanced growth, but its claim that the AUD remains overvalued rings hollow.

On a variety of valuation metrics, the AUD is now about where it should be – or even too low if gold still has a role in determining ‘fair value.

Further AUD weakness is justified only if key fundamental drivers move further against the AUD, as NAB expects.

In examining a range of metrics by which to judge appropriate levels for the AUD, we contend that the RBA’s continuing claims of an overvalued currency ring increasingly hollow. While we agree that the AUD should fall further based on the likely behaviour of some of its key historical drivers, we suspect that the current claims of overvaluation are being made in large part because the RBA is fearful that if it stops saying it, the currency will come under fresh undesired upward pressure.

Selective with the truth

In the minutes of the RBA’s February Board meeting published on 17 Feb, and in the earlier post-3 Feb meeting statement by the Governor, it was “noted that the Australian dollar had depreciated noticeably against a rising US dollar over recent months, although less so against a basket of currencies, and that it remained above most estimates of its fundamental value, particularly given the significant declines in key commodity prices. Members agreed that a lower exchange rate was likely to be needed to achieve balanced growth in the economy”.

In his testimony before the House of Representatives Standing Committee on Economics on 13 Feb, Governor Stevens failed to offer up a current opinion on the fair value of the currency.  In December last year, recall, he told the AFR that if he had to pick a level for the currency, “probably 75 (US) cents is better than 85 cents” (he’d first mentioned 85 cents, a year earlier, when the currency was trading closer to 95 cents).

It is an easy claim to make that the trade-weighted AUD (TWI) has fallen by much less that the recent decline in key commodity prices. The RBA’s commodity prices index (whether in USD or SDR terms) is down about 20% in the year through January, yet the RBA AUD TWI has only fallen by 5.6% over the same period. But the peak-to-trough decline in the AUD TWI since its (April 2013) peak has been about 22%, not far short of the 25% decline in Australia’s Terms of Trade (ToT) since its (Q3 2011) peak. Looked at this way, the currency’s fall to date meets Mr Stevens claim that “the exchange rate is more or less doing what you would expect it to do”.

Moreover, it is somewhat disingenuous to simply compare changes in commodity prices with changes in the currency and implicitly suggest they should somehow equate. Between 1998 (the start of the China-driven ToT boom) and its 2011 peak, the ToT improved by over 100% yet the AUD TWI appreciated by only about 50%. In this context, the decline in the AUD TWI from its 2013 peak could even be said to be exaggerated. We’d add that versus the USD and in TWI terms, the AUD is almost back to its post float averages

Mimicking the RBA model

In an effort to justify a claim of continued AUD overvaluation, we attempted to replicate something close to the RBA’s own preferred currency valuation model. This, we learn from material released under past Freedom of Information requests to the RBA[1] (in January and September 2014) judges the real value of the AUD TWI in relation to two key variables, namely the Goods Terms of Trade, and the real policy rate differential between Australia and the ‘G3’ (United States, Eurozone and Japan). The RBA also suggests that the strength or weakness of capital expenditure at different points in the economic cycle (e.g. very high during the construction phase of the commodity might also be relevant to the fair value of the AUD.

Estimating since 1999, we find the Real TWI ended last year very close to its model-predicted level (‘overvalued’ by less than 2%). This slight overvaluation will have already been corrected given that the TWI has fallen a further 3.8% this year.

Short term FV models at odds on AUD/USD

One issue (potential flaw) with this RBA-style model is that the real policy rate differentials term uses the official (near zero) policy rates of the Fed, ECB and BOJ, whereas their actual policy settings under their respective ‘QE’ regimes are designed to replicate the effect of negative nominal interest rates. This means that the calculated policy rate differential between Australia and the G3 is smaller than it should be, because the measured G3 rate is actually too high.

Regular readers of NAB FX Research will know that we frequently refer to a short term valuation model for the AUD/USD rate that uses as its US interest rate term an estimate of the ‘Shadow Short Rate’ (SSR) derived by the RBNZ’s Leo Krippner. This is designed to quantify the implied negative Fed Funds rate from the yield curve distortions created by Fed QE. Calculating the AUS-US interest rate differential with reference to this SSR, and using industrial metals price alongside the VIX as a risk-appetite proxy, the model has done a remarkably good job of tracking the decline in the AUD/USD rate in the past few months as the SSR has become less negative.  As of the end of January, the SSR model was giving a fair value estimate for AUD/USD of just under 78 cents, bang in line with the spot rate.

What may be instructive is that if we test the model with positive US interest rates, it suggests significantly lower levels for the AUD ahead. For example with a SSR of +1% (vs. -0.7% at end-Jan) then, all else equal, the model estimate drops to around 72 cents. This is one reason we retain a bearish view of AUD/USD over the remainder of 2015 and H1 2016.

Regular readers will also be aware that we started referencing the SSR model in 2013 alongside our more traditional short run valuation model which has as its drivers, the AU-US rate spread (2-year swaps), industrial metals, VIX and gold.

For much of 2014, our ‘traditional’ fair model, that used conventional interest rate differentials, industrial metals prices, the VIX and gold, did a much better job of tracking the spot AUD/USD rate than the SSR model. However, since about mid-November, the model appears to have broken down, producing consistently higher estimates than spot.

Gold-AUD correlation has broken down 

The primary culprit in driving the wedge between spot and the model value has been gold and where an historically high positive correlation (85% in the 10 years through 2014) has recently turned negative. It may be that negative deposit rates in the Eurozone, Switzerland and elsewhere, reducing the opportunity cost of owning gold, have introduced a fresh layer of demand for the yellow metal.

If we remove gold from our traditional model, spot and model values fall straight back into line. But since such a model will have done a lousy job from 2011 through most of 2014, we are reluctant to jettison gold from the model since the breakdown in the gold/AUD correlation has been so recent. In the meantime, we will treat the suggestion that AUD/USD has overshot to the downside, with a good deal of scepticism.

Long term valuation – are we there yet?

Finally we also note that AUD has honed in on purchasing power parity (PPP) levels of around 73 cents and our (slightly higher) PPP calculations when adjusted for changes in Australia’s terms of trade. So whether we use a variant of the RBA’s preferred AUD valuation models, our own short term fair value estimates, or longer term PPP-type modelling, all lead to a similar conclusions. The AUD at present looks quite fairly priced both against the USD and in trade-weighted terms.

For further FX, Interest rate and Commodities information visit nab.com.au/nabfinancialmarkets



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