Download ANZ Australian dollar `fair value` model

Economics@ANZ
ANZ Australian dollar ‘fair value’
model
Update: The increased importance of concurrent yields
May 2007
This research note provides an update of ANZ’s Australian dollar fair value model.1
The focus is on a re-estimation of the original equation to now include the bond
yield spread variable contemporaneously. This adds to the dynamics of the yield
spread-$A variable, which is already included in the model in lagged form, and
recognises the stronger relationship between concurrent exchange rate and yield
movements in the last 12 months. Key conclusions drawn from this analysis are:
y That shifts in the contemporaneous yield differential have become
increasingly important in “explaining” shifts in the Australian dollar. Conversely,
the explanatory power of the lagged relationship between yields and the AUD
has diminished marginally, yet remains a significant explanator of currency
movements.
y Similarly, the cash rate has become a more significant driver of shifts in
the Australian dollar in this environment of investors focussing on yields. This is
especially so as expected shifts in cash rates are increasingly ‘priced-in’ to the
currency.
Authors:
Dr. Alex Joiner
Economist, International
+61 3 9273 6123
[email protected]
y The re-estimation leaves the relationship between commodity prices and
the AUD relatively unchanged. Despite this, the outlook for commodity prices
remains the most significant “unknown” influence on the Australian dollar in the
projection period.
y The modelling results are consistent with ANZ’s view that the Australian dollar
will remain well supported above US80 cents in the medium term.
Shift in focus to concurrent yields…
The initial development of ANZ’s fair value model exploited the strong lagged
relationship between the AUD and 2-year bond yield differentials. However recently,
there is increasing evidence to suggest that this lagged relationship has weakened
marginally, in favour of contemporaneous bond yield spreads. Consequently, we
now include a contemporaneous 2-year bond yield differential variable into the
model to complement the already included lag. This serves to marginally increase
the explanatory power of the model especially in the latter 18-24 months of the
estimation period. The results of the model, which is now estimated from January
1991-April 2007, are illustrated below.
Chart 1: Australian Dollar model – results
0.9
AUD/USD
Model output - One
standard deviation band
0.8
0.7
0.6
Forecasts
0.5
AUD Actual/ANZ
forecast
0.4
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
1
The model is described in full in the original paper ANZ "Fair Value" Exchange
Rate Model: An Update.
Economics@ANZ
ANZ Australian Dollar model
As can be seen on Chart 1, the model provides a
relatively good explanation of Australian dollar
movements over the period. The observed $A
outcome is within one standard error of the
modelled estimates for much of the sample period,
especially in the last 2-3 years. The strong
performance of the ‘fitted’ $A track over the period
is reflected in the R2 of the model being just over
93%.
uses 2-year bond yield spreads; however, the
explanatory power of the model is broadly
maintained when using 3, 5 and 10 year yield
spreads. This may indicate that increasingly
domestic economic information is being reflected in
yields of longer maturity bonds, rather than the
historical mirroring of US yields. This in part reflects
an uncoupling of US and Australian monetary policy
cycles.
Much of the improvement in model performance in
the last 12-18 months has been due to the inclusion
of the yield differential contemporaneously. The
increasing importance of this relationship can be
demonstrated by examining the stability of the
coefficient estimates over time. Chart 2 shows the
results of a recursive estimation of the coefficients
on the cash rate, lagged and contemporaneous bond
yield spread variables. After initial coefficient
instability (due to the lack of observations since the
‘break-point’ in June 1999) it is important to note
that the coefficient estimators become relatively
stable throughout 2004-05 to mid-2006. However,
after mid-2006 we see what turns out to be a
statistically significant shift in the co-efficient
estimates with the lagged bond yield coefficient
decreasing in explanatory power in favour of both
the contemporaneous bond yields and the cash rate.
Crucially, we see that the contemporaneous bond
yield differential was not statistically significant
before mid-2006. This represents a shift in
exchange rate market behaviour.
It is also interesting to note that substituting the
contemporaneous 2-year bond differential between
Australia and Japan conveys similar information as
the US-Aust yield spread on movements of the AUD.
However, again the Japanese yield spread is only
statistically
significant
in
determining
AUD
movements in the last 12-18 months. This is an
unsurprising empirical result as over this period we
have seen carry trades from low yielding countries
such as Japan, be directed into the relatively high
yielding countries such as of Australia.
Chart 2: Coefficient stability
0.12
0.08
0.8
1.5
0.5
0.5
-0.5
2005
Australia-US 2 year yield spread (RHS)
92 93 94 95 96 97 98 99 00 01 02 03 04 05 06
Unlike Aust-US yield spreads, lagged information
from Aust-Japan spreads adds no significant
information on the movement of the Australian
dollar over the rest of the sample period. Given this
is an AUD/USD model only the Aust-US spread is
included for forecasting purposes.
C ontemporaneous yield
spread
2004
3.5
2.5
0
-0.06
2003
6.5
4.5
AUD/USD (LHS)
0.02
-0.04
7.5
0.7
C ash rate
-0.02
%
5.5
0.4
0.04
Australia-Japan 2 year yield
spread (RHS)
0.9
Lagged yield spread
0.06
AUD
0.6
C oefficient estimates
0.1
Chart 3: Aust-US and Aust-Japan yield spreads
1.0
2006
Alternate projections going forward….
2007
The primary use of this model is to add to the range
of tools used in the AUD forecasting process.
Specifically, the model can be used to provide an
alternative track for the Australian dollar going
forward under a variety of economic scenarios. In
this way we can ‘test’ scenarios that differ from our
baseline economic forecast.
This empirical result confirms what is being seen in
practice. That is, movements in the Australian dollar
are
being
increasingly
influenced
by
yield
differentials and cash rates contemporaneously as
market participants look to maximise yield via
instruments such as carry trades. As long as
Australia has relatively higher yields we would
expect that this contemporaneous relationship will
remain a significant influence on the Australian
dollar.
The results of our baseline forecasts are seen in
Chart 1 and Table 1 (final page). The model
suggests that the AUD will continue to be well
supported by yield differentials and cash rate rises
for the remainder of 2007 and into 2008. This
support will be tempered by a fall in commodity
prices throughout the period.
Interestingly, the relationship between the $A and
lagged and contemporaneous bond yield differentials
is robust across maturities. The model currently
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ANZ Australian Dollar model
late this year followed by hikes in late 2008. From
this, the AUD model projection is supported by
higher cash rates and a favourable yield spread
throughout much of the forecast period.
Higher commodities prices…
There has been a widespread view that commodities
prices are approaching a peak and increased supply
will see prices ease. However, this has not yet come
to pass. Stronger than expected global growth,
supply chain delays and export bottle-necks have all
kept commodity prices persistently high and
continue to present upward risks to our baseline
commodity price forecasts (of a 24% decline in
prices by December 2009).
We now test an alternate scenario in which
Australian cash rates increase to 7.0% by mid-2008,
before falling to 5.75% by the end of 2009.
Similarly, we assume the Fed Funds rate increases
to 6.0% in early 2008 and only to fall to 5.0%
throughout in 2009. Under this scenario the bond
yield differential is narrower throughout most the
forecast horizon. In addition, the cash rate ends the
forecast period at a lower rate than at the
beginning.
In our first scenario, a flat profile for commodity
prices is substituted into the model, representing
ongoing elevated commodity prices. We can see, in
Chart 4, how any upside risk to commodity prices
may impact on the level of the Australia dollar. With
assumptions around yield spreads and the cash rate
unchanged, a ‘flat’ commodities scenario adds as
much as US10 cents to the baseline AUD scenario
by the end of the forecast period. Also interesting is
the considerable upside to the AUD throughout the
forecast horizon, with a peak at over US87 cents
occurring in early 2009, compared with the current
forecast of a peak at around US84-85 cents in mid2007. The potential range of AUD outcomes that
result from commodities prices falling somewhere
between the flat and the baseline cases is denoted
by the blue shaded area in the chart below.
Chart 5: Alternate interest rates scenario
0.90
AUD/USD
0.85
0.80
Actual AUD
0.75
0.70
0.65
Baseline model
output
0.60
0.55
Chart 4: ‘Flat’ Commodities scenario
0.90
AUD/USD
0.50
'Flat' commodities premium
0.45
01
0.85
0.80
0.75
0.70
Baseline model
output
0.60
0.55
0.50
0.45
01
02
03
04
05
06
07
08
02
03
04
05
06
07
08
09
Under this scenario the AUD track produced by the
model receives significantly less support from the
cash rate and bond differentials. The AUD projection
produced by the model is a few cents lower than
that given by the baseline scenario through to 2008
as it is assumed US and Australian policy rates
move in broadly the same way. However, as the
Australian cast rate is cut more rapidly and by a
greater amount in 2009, we see significant
Australian dollar weakness through the year
eventually pushing below the US70 cent mark.
Similar, to our earlier analysis the shaded area in
the chart represents the range of AUD projection
that are possible between the baseline and alternate
scenarios.
Actual AUD
0.65
Alternate
interest rate
scenario
09
This example demonstrates just how sensitive the
Australian dollar is to potential alternative scenarios
around commodities prices. Given the simple nature
of the estimation methodology we assume that the
coefficient
estimators
are
symmetrical.
Consequently, mirroring the flat-line commodities
scenario on the other side of our baseline forecast,
to give a 48% fall in commodity prices (back to
2003 levels), could potentially see the AUD fall to
below US70 cents.
The cornerstone of our model is to provide
projections for the $A based on economic variables
that we forecast. However, these underlying
economic forecasts are by no means set in stone.
What we have demonstrated here is that our
Australian dollar model is a useful tool in the
analysis of a variety of possible economic scenarios
and provides insight into various up and downside
risks to the currency going forward.
Yield spreads narrow, policy rates rise & fall…
Similar analysis can be undertaken with an alternate
interest rate, and subsequently yield differential,
scenario. Currently our baseline case is for two more
increases in the Australian cash rate over the
forecast period and for cuts in the Fed Funds rate
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Economics@ANZ
ANZ Australian Dollar model
Table1:
Australian Dollar model forecast inputs
Actual $A &
ANZ forecasts
FV model
output
Cash rate
2-year yield
spread
RBA
commodities
index
Jul-06
0.7663
0.7536
5.75
1.034
207.25
Aug-06
0.7637
0.7721
6.00
1.065
208.27
Sep-06
0.7459
0.7657
6.00
1.171
205.63
Oct-06
0.7738
0.7682
6.00
1.421
208.99
Nov-06
0.7889
0.7862
6.25
1.448
213.86
Dec-06
0.7886
0.7868
6.25
1.405
215.88
Mar-07
0.8086
0.7824
6.25
1.720
219.38
Jun-07 (f)
0.8300
0.7862
6.25
1.413
226.17
Sep-07 (f)
0.8100
0.7982
6.25
1.763
214.06
Dec-07 (f)
0.8100
0.8199
6.50
2.063
207.10
Mar-08 (f)
0.8000
0.8259
6.50
1.913
204.50
Jun-08 (f)
0.7900
0.7913
6.50
1.463
199.19
Sep-08 (f)
0.7600
0.7883
6.50
1.213
192.01
Dec-08 (f)
0.7400
0.8001
6.50
1.413
189.50
Source: Economics@ANZ, Bloomberg
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ANZ Australian Dollar model
ANZ Research
Economics@ANZ
Saul Eslake
Chief Economist
+61 3 9273 6251
[email protected]
Fiona Allen
Business Manager
+61 3 9273 6224
[email protected]
Tony Pearson
Head of Australian
Economics
+61 3 9273 5083
[email protected]
Julie Toth
Senior Economist,
Industry
+61 3 9273 6252
[email protected]
Mark Rodrigues
Senior Economist,
Australia
+61 3 9273 6286
[email protected]
Amy Auster
Katie Dean
Jasmine Robinson Dr. Alex Joiner
Head of International
Economics
+61 3 9273 5417
[email protected]
Senior Economist,
International
+61 3 9273 5466
[email protected]
Senior Economist,
International
+61 3 9273 6289
[email protected]
Economist,
International
+61 3 9273 6123
[email protected]
Paul Braddick
Head of Financial
System Analysis
Ange Montalti
Senior Economist,
Financial System
Analysis
+61 3 9273 6288
[email protected]
Tony Morriss
Senior Currency
Strategist
+61 2 9226 6757
[email protected]
+61 3 9273 5987
[email protected]
Warren Hogan
Head of Markets
Research
+61 2 9227 1562
[email protected]
+61 3 9273 1995
[email protected]
ANZ Investment
Bank
Warren Hogan
Head of Markets
Research
+61 2 9227 1562
[email protected]
Sally Auld
Senior Interest Rate
Strategist
+61 2 9227 1809
[email protected]
Sarah Percy-Dove
Head of Credit
Research
+61 2 9227 1142
[email protected]
John Manning
Bradley Bugg
Senior Credit Analyst Senior Credit
Analyst
+61 2 9227 1493
+61 2 9227 1693
[email protected]
[email protected]
Research &
Information
Services
Mary Yaxley
Marilla Chant
Head of Research &
Information Services
+61 3 9273 6265
[email protected]
Senior Information
Officer
+61 3 9273 6263
[email protected]
ANZ New Zealand
Cameron Bagrie
Chief Economist
+64 4 802 2212
[email protected]
Khoon Goh
Senior Economist
+64 4 802 2357
[email protected]
Philip Borkin
Economist
+64 4 802 2199
[email protected]
Sean Comber
Economist
Steve Edwards
Economist
Kevin Wilson
Rural Economist
+64 4 802 2286
[email protected]
+64 4 802 2217
[email protected]
+64 4 802 2361
Kevin.Wilson@nbnz.
co.nz
Riki Polygenis
Economist,
Australia
+61 3 9273 4060
[email protected]
Amber Rabinov
Economist,
Australia
+61 3 9273 4853
[email protected]
Wain Yuen
Economist,
Industry
+61 3 9273 6295
[email protected]
David Croy
Strategist
Cherelle Murphy
Economist, Markets
Patricia Gacis
Fixed Income Analyst
+44 20 7378 2070
[email protected]
+61 3 9273 1995
[email protected]
+61 2 9227 1272
[email protected]
Cherelle Murphy
Economist, Markets
Manesha
Jayasuriya
Information Officer
+61 3 9273 4121
[email protected]
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ANZ Australian Dollar model
Important Notice
Australia and New Zealand Banking Group Limited is represented in:
AUSTRALIA by:
Australia and New Zealand Banking Group Limited ABN 11 005 357 522
10th Floor 100 Queen Street, Melbourne 3000, Australia
Telephone +61 3 9273 6224
Fax +61 3 9273 5711
UNITED KINGDOM by:
Australia and New Zealand Banking Group Limited
ABN 11 005 357 522
40 Bank Street, Canary Wharf, London, E14 5EJ, United Kingdom
Telephone +44 20 3229 2121
Fax +44 20 7378 2378
UNITED STATES OF AMERICA by:
ANZ Securities, Inc. (Member of NASD and SIPC)
6th Floor 1177 Avenue of the Americas
New York, NY 10036, United States of America
Tel: +1 212 801 9160
Fax: +1 212 801 9163
NEW ZEALAND by:
ANZ National Bank Limited
Level 7, 1-9 Victoria Street, Wellington, New Zealand
Telephone +64 4 802 2000
In Australia and the UK, ANZ Investment Bank is a business name of Australia and New Zealand Banking Group
Limited, ABN 11 005 357 522 (“ANZBGL”) which is incorporated with limited liability in Australia. ANZBGL holds an
Australian Financial Services licence no. 234527 and is authorised in the UK by the Financial Services Authority (“FSA”).
In New Zealand, ANZ Investment Bank is a business name of ANZ National Bank Limited WN / 035976 (“ANZ NZ”).
This document is being distributed in the United States by ANZ Securities, Inc. (“ANZ S”) (an affiliated company of
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