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JP Morgan has a new way of forecasting the Australian dollar

Currency experts have had to overcome their pride, and their persistently wayward Australian dollar forecasts, and instead develop a different model for charting the direction of the local currency, as it moves against the US dollar.

Shifting commodity prices and a gap in interest rate spreads are complicating Aussie dollar forecasts, but JP Morgan suggests averaging the likes of major commodity prices and combining a 1Yx3M real yield spread with an existing terms of trade forecast to predict the direction of the currency movements.

The Australian dollar should trade around the US75¢-US78¢ range in the second half of this year, before trading down towards US72¢ by mid-2018, says JP Morgan. Two months ago, JP Morgan had expected the Aussie to sit around US72¢ at the end of the third quarter. But based on this improved model, Sally Auld and Ben Jarmon, Australian and New Zealand interest rate strategists at JP Morgan, now expect the Australian dollar to trade around the US75¢-US78¢ range in the second half of this year, before trading down towards US72¢ by mid-2018.

"This bearish profile hasn't been the right one for AUD/USD so far this year," writes Ms Auld. "But assuming otherwise would demand faith in persistent low US inflation outcomes, assume no mean reversion in the US dollar, no further moderation in Chinese growth, stable to higher commodity prices and upside risks to the domestic demand story in Australia."

Commodity prices have moved around a lot this year and as such, the terms of trade figures forecast by banks can vary dramatically to the actual value.

"If large enough, this deviation can drive strong conclusions about both the mis-valuation and expected near-term direction of the currency," say the strategists.

Additionally, China's unpredictable policy decisions that flow through to market pricing of commodities such as iron ore mean foreign exchange experts are often left scrambling to adjust to the changes in credit and liquidity.

"These mini-turns in financial conditions have not been easy to predict ahead of time, the cycle length is shortening, and the transmission to commodities looks more speculative than fundamental," say the JP Morgan team." Still, this has been influential for the Australian dollar and needs to be incorporated in any short-term valuation framework, by tracking commodity prices in real time."

To accurately represent changes in commodity prices, the team suggests using a fair value model, made up of a broad index of commodity prices. In this instance a CRB Index (a commodity futures price index) is used. The index is made up of 19 commodities, sorted into four groups with different weightings.

"[This would] provide a 'manual override' for the current quarter terms of trade forecast when spot prices aren't tracking as per the forecast," explains Ms Auld.

The US dollar movements – decidedly lower in recent times – has also played havoc with currency forecasts and, given commodities are largely priced in US dollars, including the CRB Index should recognise moves in the global reserve currency.

"We now have a somewhat formal mechanism to capture the dollar discount rather than just relying upon judgment," writes Ms Auld. "We also have a method of reflecting the impact of spot commodity prices on AUD fair value estimates, should they diverge materially from forecasts."

This representation of the terms of trade needs to be combined with a measure of interest rate spreads. JP Morgan found the spread between AUD-USD one year and three month real yield works well, given that it captures information on the current spread and expectations about where markets see the spread going and it can explain almost 70 per cent of the variation in the AUD/USD movements.

"In terms of forecasts, we can make some broad assumptions around the real rate spread, using our respective core inflation forecasts for Australia and the US, and our respective monetary policy views," say the team.

"Using market variables (as opposed to forecast policy rates) also allows some discretion to consider the likely path of market pricing."

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