- Australian Dollar forecasts downgraded at J.P. Morgan.

- Interest rate divergence primary driver of exchange rates.

- AUD/USD facing minor losses, GBP/AUD eyes 5% upside.

© kasto, Adobe Stock

The Australian Dollar is tipped to face further losses during the months ahead, according to the latest forecasts from the world's largest investment bank, J.P. Morgan.

J.P. Morgan forecasts suggest any strength in the Aussie will likely prove to be short-lived as what will matter most for the Aussie Dollar are developments around domestic monetary policy, as well as interest rates elsewhere in the world.

"We expect both monetary policy divergence and minimal support from commodity prices to push the currency lower over time. We are also expecting the pace of domestic growth momentum to decline in 2H18, after a boost from net exports in the first half of the year," writes Sally Auld, chief Australia and New Zealand economist at J.P. Morgan, in a recent briefing.

Above: AUD/USD rate shown at weekly intervals.

Australian interest rates have been held at a record low of 1.5% for approaching two years now and, at the time of writing, markets do not expect a change in RBA policy until well into the second half of 2019.

Markets are pessimistic about Aussie interest rats despite the RBA continuing to sound an upbeat tone on the domestic economic outlook, forecasting GDP growth of around 3% or more this year and next, as well as further improvement in the labour market and a gradual uptick in inflation.

"Progress is expected to be slow on both fronts. This places little pressure on the current “perma-hold” strategy, further entrenching the divergence of Australia's monetary policy with most of the G10," Auld says.

This is a problem for the Aussie because other central banks, such as the Federal Reserve, Bank of Canada and Bank of England, have long-since begun to raise their interest rates as the global economic recovery from the financial crisis enters its advanced stages. Even the European Central Bank is expected to raise its interest rate, in June 2019, before the RBA does.

As a result, the yield differential between Australian and other government bonds has moved to a less advantageous level for the Antipodean currency in a number of instances, while it is now outright disadvantageous when Aussie bonds are stood next to their US counterparts. The latter is the result of the Fed having raised its interest rate, which now sits above the Aussie cash rate, six times since the end of 2015.

Above: US 10 Year Government Bond Yield.

"AUD has fallen victim to the USD's out-performance of late, but has held in better on a trade weighted basis. Indeed, since the USD troughed in mid-April, the AUD has declined 4%, a respectable “mid-pack” performance relative to G10 peers," Auld says.

US 10 year treasury yields broke above 3.1% Thursday to reach a new 7-year high and remained close to this level Friday, further widening the newly opened gulf between them and those of their Aussie counterparts, which trail behind with a yield of around 2.9%.

Above: Australian 10 Year Government Bond Yield.

That means investors are further incentivised to sell Aussie Dollars and buy the greenback in order to invest in the American bond market rather than vice versa.

However, despite all of this, Auld and the J.P. Morgan team say the Aussie Dollar may be able to avoid further losses in the short term, potentially until the end of June, if global economic growth momentum remains at decent enough levels.

"Given our economists’ expectations of a rebound in global growth in 2Q and our sense that much of the recent move in the USD is positioning driven, we are reluctant to view recent price action as accelerating AUD’s decline towards the low 70s. We have therefore made only modest changes to our forecast trajectory," Auld writes.

Auld's forecasts suggest the AUD/USD rate could rise from 0.75 to 0.76 before the end of the second quarter but, after this point, the exchange rate will resume its earlier decline. The J.P. Morgan team have the Aussie unit declining steadily to 0.74 over the second half of the year before falling even further, to 0.73, before the end of the first-quarter 2019. Most of these represent downgrades from earlier forecasts of 0.78, 0.76, 0.75 and 0.73 respectively.

"From a valuation perspective, AUD/USD looks a little cheap relative to fair value at present vs the USD, but not excessively so," Auld notes.

For the Pound-to-Australian-Dollar rate, J.P. Morgan has also ajusted its forecasts. Following simultaneous downgrades to both the Aussie and Sterling, the Pound-to-Aussie rate is now seen rising from 1.79 Friday to only 1.89 by December 2018.

This is a downgrade from the earlier forecast of 1.92 but, nonetheless, still implies an increase of 5.5% for UK based buyers of the Aussie Dollar this year.

Above: Pound-to-Aussie rate shown at weekly intervals.

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