Australian lender Westpac’s currency attribution model continues to favour the Australian dollar

Analysts at Westpac have a clever model which allocates a hypothetical portfolio of G10 currencies differing amounts depending on which currencies it has determined will go up or down.

The model uses a variety of econometric, valuation and technical data to decide what percentage share of the portfolio should be allocated to each currency.

In the most recent week the Aussie dollar remained the currency with the largest share.

It was a “core bet for the model,” with 22.7% of the portfolio in Australian dollars, according to Westpac’s Richard Franulovich, who added:

“The Westpac G10 FX model continues to advocate a risk positive stance, the portfolio still heavily long AUD (+22.7% of the portfolio).

“The model remains wary European currencies too and wants to fade JPY weakness due to the yen’s cheap long term valuations and Japan’s stronger external accounts.” He said.

The models’ strongest Aussie-positive signals are those covering the short and medium-term timespans:

“Our medium and short term signals are trending in AUD’s favour. Growth has been a reliably positive AUD signal for over a year (blue bars), the main positive inputs being the downtrend in the nation’s unemployment rate (from 6.3% to 5.8%) and the recovery in business conditions from the NAB business survey (from around +5 to +12).”

Longer-term, however, the Australian dollar may be set for some corrective downside, with Purchasing Power Parity (PPP) providing the weakest signal followed by valuation versus terms of trade:

Purchasing Power Parity evaluates whether a currency is relatively too strong or too weak by comparing the cost of similar goods priced in different currencies.

Those that are relatively speaking too expensive compared to the rest are probably so because the currency they are priced in is too expensive (suggesting it will fall).

This is the case with the Australian dollar.

“Long term factors/fundamentals remain the AUD’s Achilles heel as far as the model is concerned.”

In support of the Aussie is the total yield differential - this is the difference between Australian 10-year bond yields and other currencies’ benchmark yields.

Yield is similar to interest in that it is the money a borrower pays for the privilege of getting a large lump sum of money.

The currency with the higher yield should be stronger as it will attract more inflows from international investors seeking higher returns – or ‘yield’.

“Even allowing for the RBA rate cut in Feb 2016 and ongoing easing priced into OIS markets rates have fallen faster elsewhere (the UK and NZ come to mind), while AUD’s carry in level terms of course remains heavily positive, bested only by NZ.” Comments Franulovich.

Westpac’s proprietary ‘Logit probability signal’ is also favouring more Australian dollar gains:

“Steadier commodity prices, lower core yields and low and falling risk premia across a range of global markets have tilted our logit signal in AUD’s favour for the better part of the last several months, even allowing for a setback around Brexit.”

Despite trading at the upper end of its 2016 range, the Aussie is not considered overvalued by the Westpac model, as it has not kept up with the rise in commodity prices, yield differential and general fall in global risk aversion.

Despite the model flashing green ‘go’ lights Franulovich ends his piece with a note of caution, in particular relating to the US economy and how interest rate hike expectations could improve in the US after being dampened by Brexit – this would start to weigh on the Aussie.

“We can think of many reasons why AUD might soon hit a local peak - solid June payrolls and firm US financial conditions despite Brexit could see the Fed statement take a less dovish tone 27 July, the BoJ and PM Abe might struggle to over-deliver on hyped expectations for major fresh stimulus, a post-convention

Trump bump in the polls could weigh on risk sentiment. For the time being though the model is a strong advocate of ongoing AUD longs.” Richard Franulovich.