-Pound-to-Aussie rate hits four-month high following Trump statements.

-Threat of US-Japan trade row undermines AUD in final session of week.

-But true threat to economy is low, say CBA, AUD to recover in 2019.

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© Taras Vyshnya, Adobe Stock

Pound Sterling rose to a four month high against the Australian Dollar Friday as markets responded to President Donald Trump's suggestion that Japan, the world's third largest economy, is his next target in the so-called "trade war".

The Wall Street Journal reported Thursday that President Trump is anticipating a deterioration of the relationship between himself and Japanese Prime Minister Shinzo Abe, who the president says will take umbrage when "I tell them how much they have to pay".

This risks ensnaring all of the world's three largest economies in a tariff fight with eachother and would serve only the heighten the sense of risk aversion that has prevailed across markets so frequently in 2018, ever since President Trump first really began flexing US trade muscles back in March.

That would be bad for Australia and its Dollar because the country is in close proximity to Japan, which is Asia's second largest economy, while China is Australia's largest trading partner. If both countries become embroiled in a trade fight with the US then risks to the Australian economic outlook will rise.

The Pound-to-Australian-Dollar rate was 0.56% higher at 1.8076 during the London morning Friday, marking its highest level since May, while the AUD/USD rate was down 0.48% at fresh 18 month low of 0.7155. But some say the market reaction has been overdone.

"We don’t believe Australia’s economy will be impacted by the potential escalation in trade frictions between the U.S. and Japan. A significant share of the exports Australia send to Japan are energy exports, which are a necessity for Japan’s economy, and are locked into long-term export supply contracts," says Elias Haddad, a strategist at Commonwealth Bank of Australia.

Trade between the US and Japan is significant, although the US had a goods deficit of $68 billion for the 2017 year that has shown no signs of receding thus far in 2018. Census Bureau data shows the US-Japan goods trade deficit reached $40 billion during the sevent months to the end of July, placing it on course to exceed last year's number if the recent trend continues.

Trump has already made clear he sees trade deficits as a sign of an unhealthy, as well as "unfair", trade relationship. Reducing the bilateral deficit has been a key aim in the White House's tariff fight with China but Grace's comments suggest the actual fallout for Australia would be minimal if Trump were to pursue the same strategy with Japan.

This leaves Friday's price action looking like a symptom of the Australian Dollar's position as a risk and confidence barometer for markets. It is, after all, underwritten by Australia's commodity exports to the rest of the world and prices of those commodities are sensitive to changes in sentiment toward the global economy, but particularly China and the US.

"AUD/USD is only impacted as far as its source of liquidity provides a useful proxy for selling when financial stress, as moderate as the stress may be, occurs. Part of the logic is AUD is the most liquid Asian currency behind JPY, Australia sends 76% of its exports to Asia, and because Australia maintains a current account deficit," Haddad writes, in a note to clients Friday.

Haddad and the Commonwealth Bank currency team forecast the AUD/USD rate will rise steadily throughout the next year or so, and that the Pound-to-Australian-Dollar rate will fall by more than 5% before the end of March 2019 and remain at depressed levels until the end of that year.

The rationale behind these forecasts is that uncertainty over the shape of the future relationship between the UK and European Union will weigh on Sterling for some time to come, even after Brexit day in March 2019, as its impact on the economy may not become known for some time.

Meanwhile, an anticipated weakening of the US Dollar is expected to enable the AUD/USD rate to rise steadily during the year ahead, with the recovery from 2018's 8% year-to-date decline being supported toward the end of 2019 by speculation the Reserve Bank of Australia will soon raise its interest rate.

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