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Analysts at the world's largest investment bank see the potential for nearly 10% upside for Sterling against the Australian Dollar this year.

The Australian Dollar advanced on the Pound during early trading in London Tuesday and extended its recent gains over a broader basket of developed world currencies, after drawing support from higher commodity prices overnight.

Both iron ore and gas prices ticked higher Tuesday, helping the Aussie currency, which has risen steadily in the last week due to a weak US Dollar and solid January employment report.

However, these gains could prove short-lived if the latest forecasts from J.P. Morgan are right in that things are about as good as they are likely to get for the Antipodean currency.

“We expect both monetary policy divergence and modestly weaker commodity prices to push the currency lower,” says Niall O’Connor, an FX strategist at J.P. Morgan, in a recent note.

“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.”

Monetary policy divergence will see a closing gap between Australian and global interest rates increasingly undermine the currency as the yield on US Treasury bonds could soon become higher than those of their Aussie rivals.

The Reserve Bank of Australia held its cash rate at a record low of 1.5% for the 19th month in a row this February and pricing in interest rate derivatives markets currently implies that rates will remain here until well into 2019.

Meanwhile, those same interest rate markets are betting that an interest rate hike from the Federal Reserve in March is all but a certainty, which would put US interest rates neck and neck with the Australian cash rate of 1.5%.

Australia’s currency has traditionally benefited from the higher yields offered by Aussie bonds relative to other developed world alternatives.

The AUD/USD rate was quoted 0.21% higher at 0.7926 Tuesday while the Pound-to-Australian-Dollar rate was 0.37% lower at 1.7624.

RBA: Patiently Waiting

February statements from RBA Governor Philip Lowe suggest Australian policymakers expect inflation will remain below the midpoint of the 2% to 3% target range for “the next couple of years”.

“This underscores that AUD will not see support from tighter monetary policy anytime soon. We continue to see the RBA on hold in 2018, as lackluster macroeconomic outcomes prevent rate normalization,” the strategist wrote, in a recent currency briefing.

“But still solid Chinese growth in 2018 and little change in the terms of trade profile in the year ahead mean that the currency should find some near term support and further, imply that the pace of decline is likely to be slow, initially.”

O’Connor’s projection for a slow and orderly decline of the Aussie Dollar is supported by the fact that J.P. Morgan’s financial valuation models currently show it as being fairly valued.

However, this is unlikely enough to prevent a decline of the currency when global bond yields overtake those of the Aussie and the economy slows.

Pound Sterling Upgraded at J.P. Morgan

While J.P. Morgan’s new forecasts still imply some downside for the Australian Dollar, the opposite is true for the bank’s view on Pound Sterling.

UK economic growth continued in 2017 at a stronger pace than almost all economists had forecast, leading to a wave of upgrades at the start of 2018, including from the Bank of England.

“The modest acceleration in UK growth to around 2% doubtless contributed to the reversal of speculative positioning in GBP from heavily short to heavily long as it led to a firming up of UK rate expectations and the promotion of GBP to the vanguard of currencies where central banks are in the early stages of policy normalisation,” says Thomas Anthonj, another strategist at J.P. Morgan.

Most importantly, these upgraded economic forecasts led the BoE to warn markets in February that it will raise interest rates faster than previously guided if the inflation outlook evolves in line with its latest projections for consumer prices.

UK inflation remained stubbornly at the 3% level in January while core inflation, which removes volatile energy and food prices from the equation, actually marched higher.

This is the result of a combination of the past depreciation of the Pound and last year’s rise in oil and gas prices. Brent crude, the European benchmark, has risen by more than 17% during the last 12 months alone.

Now, markets are betting that the Bank of England will raise interest rates one and a half times in 2018 when, just six weeks ago, the jury was out on whether the BoE would manage even a single rate rise.

This, combined with a weaker US Dollar, has led to significant gains for the Pound, resulting in a series of forecast upgrades.

Forecasts: 10% Upside for Sterling-Aussie

J.P. Morgan has upgraded its forecasts for both the Pound and Australian Dollar relative to the US Dollar, which has implications for the Pound-to-Aussie rate.

“Our new forecast track expects AUD/USD to hold around the USD0.78-80c level in 1H18, before declining towards USD0.75c by year end,” O’Connor says.

Pound-to-Aussie is, after all, a foreign exchange cross rate that is calculated at its most basic level by dividing the Pound-Dollar rate over the Aussie-to-Dollar rate.

In order for the Sterling to rise against the Aussie, the Pound must move further and faster against the Dollar than its Antipodean counterpart does.

“The 1Y cable [GBPUSD] forecast is now a 1.45, up from 1.34 previously. The balance of risks to the new forecasts are for a weaker GBP,” writes Anthonj, in a recent note.

The net effect of these two sets of forecasts is an implicit expectation that the Pound will rise substantially against the Australian Dollar over the course of 2018, ending the year at 1.9333.

This is vastly higher the 1.7654 level seen by the Pound-to-Australian-Dollar rate Tuesday, implying a rise of some 9.6% is likely before the end of December.

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