-AUD shrugs off "terms of trade" deterioration in second quarter.

-Currency now 6% undervalued and the bigger picture is bright.

-CIBC forecast steep recovery for AUD before 2018 year is out.

© Taras Vyshnya, Adobe Stock

The Australian Dollar rose Friday, drawing a line under earlier losses brought on by a deterioration in Australia's "terms of trade", and it could continue to rise during coming days if analysts are right in saying the Antipodean currency is "poised for a turnaround".

Australian import prices rose by an average of 3.2% when second-quarter goods numbers are compared with those of the prior period, while export prices ticked only 1.9% higher. This is known as a deterioration in the "terms of trade" which, helping to dictate the fundamental value of a currency, spurred fresh losses for the Aussie Dollar Thursday.

However, the data were not as bad as the headline numbers suggest, given that export prices actually rose faster than import prices when second quarter data are compared with their counterparts from one year ago, rather than simply the first quarter 2018 numbers.

Much of the uplift in the annual import-export price balance came from an increase in the price of commodities sold on international markets by Australian firms. Liquified natural gas prices have risen substantially this year, in line with the 15% or more rise in the price of crude oil, while agricultural commodity prices have risen too.

"This unexpected broad-based leap in hard and soft commodity export prices is encouraging for trade and economic growth. Even if the terms of trade fell -1%/q, the annual pace jumps to 2.5%/y given favourable base effects," says Annette Beacher, chief Asia Pacific macro strategist at TD Securities. "For the AUD the terms of trade is a medium-term driver of the exchange rate, and closely followed by the RBA."

Beacher says the TD Securities financial model places "fair value" for the Australian Dollar at around 0.7520 per US Dollar, which is substantially above the market price, suggesting the Aussie unit is undervalued by more than 6% at current levels. Currencies frequently swing between being undervalued or overvalued and normally tend to reverse course when they reach points at which markets perceive the valuation mismatch to be at an extreme.

The AUD/USD rate was quoted 0.11% higher at 0.7389 Friday while the Pound-to-Aussie rate was 0.15% lower at 1.7734. The Australian Dollar was also quoted higher against all other developed world currencies except the Japanese Yen Friday.

Australia's Dollar has now lost 5.19% against the US Dollar in 2018 and 2.99% against Pound Sterling, although it has fallen further than that in recent months, because it had risen by similar measures during the first quarter of the year.

This dire performance has been driven largely by a Reserve Bank of Australia (RBA) that has sat on its hands at a time when central banks elsewhere in the world are raising their interest rates or otherwise withdraw post-crisis stimulus from economies.

The Reserve Bank of Australia has held its interest rate at a record low of 1.5% for 23 consecutive months, citing below-target inflation and a debt laden household sector that it says is ill-equipped to handle the pressures of higher borrowing costs given years of weak wage growth.

Few see a change in policy until at least the middle of 2019 however, some are now arguing the market is danger of becoming too pessimistic in its outlook for Australian monetary policy and that may already have lost sight of fundamental strength in the nation's economy.

The Aussie has long enjoyed support from interest rates that were typically higher than those elsewhere in the developed world, although it no longer has any interest rate advantage over the US and Canadian Dollars, while the UK-Australia yield gap will also narrow if the Bank of England meets expectations and raises interest rates next week.

"Investors appear to be discounting the risks of tightening in the next nine months given that growth is set to remain above trend this year and next," says Avery Shenfeld, chief economist at CIBC Capital Markets. "While that likely reflects the cyclical nature of the economy and the risks associated with protectionism, we see recent strength in economic activity as stemming from strong domestic fundamentals, which suggests that the accumulation in AUD shorts is overdone."

Australian inflation has remained below the RBA's 2% target persistently in recent years, ruling out rate hikes from the Aussie central bank. But Shenfeld and the CIBC team say Australia's strong labour market should soon rectify this as, if the economy continues to create new jobs at a healthy clip, the wage packets will eventually rise and this will feed higher levels of consumer price inflation.

Australia's economy created 59,900 new jobs during June, up from 13,400 in May and far ahead of the consensus for an increase of 16,700. This was by-far the highest number of new jobs created in any month of the year to date.

This left the unemployment rate steady at 5.4%, in-line with expectations, despite a simultaneous 0.2% increase in the participation rate that meant there were more Australians who are technically classified as unemployed during the period.

Australian jobs growth had previously disapointed through much of 2018. After a 12 month period of jobs gains that were often in excess of 40,000 per month, new job creation averaged little more than 14,000 during the first five months of the year.

"While we pared back AUD strength over the back half of 2019 owing to a slowing in global growth that will impact Australia’s export prospects, we still see an appreciation in AUDUSD to 0.78 by the end of 2018, assuming that global trade tensions remain contained," Shenfeld concludes.

Shenfeld and the CIBC team also forecast the Pound-to-Australian-Dollar rate will fall to 1.7050 before the year is out.

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