Australian Dollar Overvalued by 11% but Tipped to Go Yet Higher vs. Pound and US Dollar in 2018

The Australian Dollar is forecast to rise against both the British Pound and US Dollar through 2018 before it starts to correct back from overvalued levels in 2019.

Analysis of the Australian Dollar's valuation conducted by global financial services provider UniCredit confirms the currency is trading well above fair-value - the level that it would be expected to be at based on current economic and financial conditions.

UniCredit calculate the Australian Dollar is overvalued by 11.0% but it will not likely fall back towards fair-value until 2019 at the earliest.

The commodity dollars - of which the Australian Dollar is classed - are expected to enjoy a decent 2018 as the external environment will remain supportive to commodity prices in 2018.

Australia's top foreign currency earners are iron ore and coal - both are expected to remain supported by Chinese demand in 2018.

Australia's domestic economy is also seen as being in relatively good shape, particularly the labour market.

However, significant advances for the Aussie currency are unlikely as the Reserve Bank of Australia (RBA) is expected to prove reluctant to raise interest rates because wage growth is slow and households are heavily indebted, thus if they increased interest rates it could have a very negative impact on the economy by making loan repayments increasingly unaffordable.

Raising interest rates could also make an already expensive AUD yet more expensive as the currency tends to benefit when the RBA is on an interest rate raising path.

"Australian fundamentals are solid, but the RBA has already flagged its resistance to joining other central banks in normalising interest rates due to the high level of household debt and weak wage growth," say UniCredit.

The market pricing of Aussie interest rate futures implies that there is a 60% probability of a rate rise in the next 12 months and a 90% chance of two rate rises in the next 24 months.

US Dollar Overvaluation

Ensuring the Australian Dollar won't fall back to fair-value anytime soon is the observation that the US Dollar is also overvalued, to the tune of 5.0% on a trade-weighted basis (which means against a basket of its most heavily traded counterparts).

The disparity between the market value and the assumed fair-value derived from UniCredit's models is due to the US Dollar making a 'technical' recovery at the start of 2017 owing to an imbalance of negative bets which saw the currency overshoot in the process of righting itself.

The main driver for the re-calibration of the Dollar is cyclical as the Dollar shows a consistent pattern of peaking and rolling over at this stage in the Federal Reserve's tightening cycle.

'Tightening' is when the central bank starts a period of rising interest rates - initially the higher interest rates boost the Dollar as they are indicative of economic growth, however, after a while the higher interest rates start to slow growth and the business cycle begins to roll-over, and when this happens the Dollar peaks and rolls over as well.

Meanwhile, UniCredit do not believe the Dollar will find any benefit from Donald Trump's attempts to lower taxes in the US.

"The implementation of US tax reform – whatever the minor variations – is unlikely to turn things around this time. As discussed in our US country section, tax cuts should produce a modest temporary boost to growth but will not fundamentally alter the long-term trajectory of the economy," say Unicredit.

In actual fact by increasing the government's borrowing requirement and US government debt, tax cuts could over time weaken the US Dollar by worsening its fiscal position.

What Does this Mean for the Australian Dollar Outlook?

By the end of 2018, one Aussie Dollar it will be able to buy 0.8200 US Dollars, confirming the Aussie Dollar's period of overvaluation is likely to extend.

But come 2019, the Aussie will lose ground again and the AUD/USD pair will be a pull-back to 0.7900 as the US Dollar's period of correction ends and the Australian Dollar commences its own period of correction.

What Does this Mean for the Pound vs. Australian Dollar Exchange Rate?

Using Unicredit's forecast for GBP/USD and AUD/USD and combining them, we can also calculate what their implied forecast is for GBP/AUD. 

UniCredit forecast GBP/USD will reach 1.37 by end of 2018 and 1.42 by end of 2019.

For GBP/AUD this translates into a 4.9% fall in 2018 which would take it from its current level of 1.7523 to 1.6665.

In 2019 there will be a reversal, however, as Sterling continues to rise whilst the Aussie weakens, with the result that the pair will rise by 7.3% to an end of 2019 target of 1.7882.

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