GBP/AUD seen at 1.66 by June, 1.63 in SeptemberEstimated to be fairly valued between 1.4492, 1.66Commodity prices, BoE & RBA policy each at play

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The Australian Dollar is likely to outperform Pound Sterling during the weeks and months ahead according to Commonwealth Bank of Australia (CBA) research, with elevated commodity prices and shifting central bank policies conspiring to drive GBP/AUD down to 1.66 this quarter.

Australia’s Dollar has already pushed the Pound more than five percent lower for the year-to-date by Wednesday but updated research suggests GBP/AUD’s 2022 decline could double before the end of the second quarter, likely pulling it down to 1.66 while lifting AUD/GBP to 0.60.

“We expect AUD/GBP to lift in the coming months as firm commodity prices support the Australian economy but drag on UK economic activity. The AUD/GBP is undervalued relative to fundamentals,” says Kristina Clifton, a senior economist and currency strategist at Commonwealth Bank of Australia.

“Our equation shows that the fair value of the AUD/GBP has been rising since late last year because of rising commodity prices and wider interest rate differentials. Fair value centres on 0.65 [GBP/AUD: 1.5384], with a range of 0.60 to 0.69 [GBP/AUD: 1.4492 to 1.6666],” Clifton said on Monday.

Above: CBA model estimate of fair value for AUD/GBP exchange rate. Click image for closer inspection.

Prices of commodities and some internationally traded goods have been widely expected to remain elevated for longer since Russia invaded Ukraine in February and coronavirus containment measures began to close down key Chinese economic hubs afresh during early April.

While these factors are an all around negative for the net-importing UK economy and Sterling, high commodity prices are at least a short-term stimulant for Australian national income and one that has given the antipodean currency a relative edge over the Pound during recent weeks.

“We expect the AUD/GBP to peak in late 2022 before easing in 2023 as commodity prices pull back and financial markets begin to focus on a Fed easing cycle,” Clifton and colleagues wrote in a Monday research briefing. (Set your FX rate alert here).

The extra inflation and resulting squeeze on household incomes generated by Russia’s war in Ukraine has led the Bank of England (BoE) to become more cautious about raising interest rates further this year, dampening UK government bond yields and dimming the outlook for Sterling along the way.

Above: Pound to Australian Dollar rate at weekly intervals alongside spread - or gap - between UK and Australian 02-year government bond yields. Click image for closer inspection.

These same factors are also squeezing many households’ incomes in Australia but to a lesser extent than in the UK while the antipodean economy is also benefiting from enhanced national income due to the increased level of Australian export commodity prices.

“The UK current account deficit is also likely to widen in the near term as high energy costs increase import values. The wider UK current account deficit relative to the US will weigh on GBP/USD,” CBA’s Clifton says.

“A country with a current account deficit is a net importer of foreign capital. An increase in the current account deficit means increased demand for foreign capital which tends to result in a depreciation of the exchange rate all else being equal,” she also said on Monday.

Rising export prices are offsetting the market impact of more costly import prices for the Australian Dollar while enlarging the UK’s cumbersome trade and current account deficits with adverse implications for Sterling.

Above: Interbank rates and performances over various horizons for all pairs included in the RBA’s trade-weighted Australian Dollar index. Source: Netdania Markets. Click image for closer inspection.

This is all a big part of why the CBA research team expects the AUD/USD exchange rate to rise faster than GBP/USD during the weeks and months ahead, which is a recipe for a falling Pound to Australian Dollar exchange rate and rising AUD/GBP.

The Pound to Australian Dollar always tends to closely reflect the relative performances of Sterling and the Aussie when each is measured against the U.S. Dollar, which the CBA team expects to ease lower throughout the remainder of the year.

“We expect slowing UK economic activity thanks to high inflation and energy costs will limit how far the BoE takes interest rates. GBP can fall if markets unwind expectations for BoE rate hikes. We expect a weak USD will take GBP/USD higher later this year and in early 2023,” CBA said last month.

“The main risk to our forecasts for 2022 is AUD/USD’s upswing may be more aggressive,” the bank also said in its April forecast review.

Above: Commonwealth Bank of Australia forecasts for Australian Dollar exchange rates. Click image for closer inspection.