ANZ Australian dollar fair value model

Transcription

1 ANZ Australian dollar fair value model Update: The increased importance of concurrent yields May 2007 Authors: Dr. Alex Joiner Economist, International joinera@anz.com 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: 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. 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. 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. 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 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 AUD/USD Model output - One standard deviation band AUD Actual/ANZ forecast Forecasts The model is described in full in the original paper ANZ "Fair Value" Exchange Rate Model: An Update.

2 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 R 2 of the model being just over 93%. Much of the improvement in model performance in the last 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 to mid 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 This represents a shift in exchange rate market behaviour Chart 2: Coefficient stability Coefficient estimates Lagged yield spread Cash rate Contemporaneous yield spread 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. Interestingly, the relationship between the $A and lagged and contemporaneous bond yield differentials is robust across maturities. The model currently ANZ Australian Dollar model 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. 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 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 3: Aust-US and Aust-Japan yield spreads AUD Australia-Japan 2 year yield % spread (RHS) AUD/USD (LHS) Australia-US 2 year yield spread (RHS) 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. Alternate projections going forward. 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. 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 This support will be tempered by a fall in commodity prices throughout the period Page 2

3 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). 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 mid 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 4: Flat Commodities scenario AUD/USD Actual AUD 'Flat' commodities premium Baseline model output 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. 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 ANZ Australian Dollar model late this year followed by hikes in late From this, the AUD model projection is supported by higher cash rates and a favourable yield spread throughout much of the forecast period. 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 Similarly, we assume the Fed Funds rate increases to 6.0% in early 2008 and only to fall to 5.0% throughout in 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 Chart 5: Alternate interest rates scenario AUD/USD Actual AUD Baseline model output Alternate interest rate scenario 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. 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. Page 3

4 ANZ Australian Dollar model Actual $A & ANZ forecasts Table1: Australian Dollar model forecast inputs FV model output Cash rate 2-year yield spread RBA commodities index Jul Aug Sep Oct Nov Dec Mar Jun-07 (f) Sep-07 (f) Dec-07 (f) Mar-08 (f) Jun-08 (f) Sep-08 (f) Dec-08 (f) Source: Bloomberg Page 4

5 ANZ Australian Dollar model ANZ Research Saul Eslake Fiona Allen Chief Economist Business Manager eslakes@anz.com allenf@anz.com Tony Pearson Julie Toth Mark Rodrigues Riki Polygenis Amber Rabinov Wain Yuen Head of Australian Economics Senior Economist, Industry Senior Economist, Australia Economist, Australia Economist, Australia Economist, Industry pearsont@anz.com tothj@anz.com rodrigum@anz.com polygenr@anz.com rabinova@anz.com yuenw@anz.com Amy Auster Katie Dean Jasmine Robinson Dr. Alex Joiner Head of International Senior Economist, Senior Economist, Economist, Economics International International International austera@anz.com deank1@anz.com robinsj7@anz.com joinera@anz.com Paul Braddick Ange Montalti Head of Financial System Analysis Senior Economist, Financial System Analysis braddicp@anz.com montalta@anz.com Warren Hogan Cherelle Murphy Head of Markets Economist, Markets Research hoganw1@anz.com murphc10@anz.com ANZ Investment Bank Warren Hogan Sally Auld Tony Morriss David Croy Cherelle Murphy Patricia Gacis Head of Markets Senior Interest Rate Senior Currency Strategist Economist, Markets Fixed Income Analyst Research Strategist Strategist hoganw1@anz.com aulds@anz.com morria15@anz.com croyd@anz.com murphc10@anz.com gacisp@anz.com Sarah Percy-Dove John Manning Bradley Bugg Head of Credit Research Senior Credit Analyst Senior Credit Analyst percydos@anz.com manninj1@anz.com buggb@anz.com Research & Information Services Mary Yaxley Marilla Chant Manesha Jayasuriya Head of Research & Senior Information Information Officer Information Services Officer yaxleym@anz.com chantm@anz.com jayasurm@anz.com ANZ New Zealand Cameron Bagrie Khoon Goh Philip Borkin Chief Economist Senior Economist Economist bagriec@anz.com gohk@anz.com borkinp@anz.com Sean Comber Steve Edwards Kevin Wilson Economist Economist Rural Economist combers@anz.com edwards1@anz.com Kevin.Wilson@nbnz. co.nz Page 5 Economics@ANZ

6 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 th Floor 100 Queen Street, Melbourne 3000, Australia Telephone Fax UNITED KINGDOM by: Australia and New Zealand Banking Group Limited ABN Bank Street, Canary Wharf, London, E14 5EJ, United Kingdom Telephone Fax 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: Fax: NEW ZEALAND by: ANZ National Bank Limited Level 7, 1-9 Victoria Street, Wellington, New Zealand Telephone In Australia and the UK, ANZ Investment Bank is a business name of Australia and New Zealand Banking Group Limited, ABN ( ANZBGL ) which is incorporated with limited liability in Australia. ANZBGL holds an Australian Financial Services licence no 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 / ( ANZ NZ ). This document is being distributed in the United States by ANZ Securities, Inc. ( ANZ S ) (an affiliated company of ANZBGL), which accepts responsibility for its content. Further information on any securities referred to herein may be obtained from ANZ S upon request. Any US person(s) receiving this document and wishing to effect transactions in any securities referred to herein should contact ANZ S, not its affiliates. This document is being distributed in the United Kingdom by ANZBGL for the information of its market counterparties and intermediate customers only. It is not intended for and must not be distributed to private customers. In the UK, ANZBGL is regulated by the FSA. Nothing here excludes or restricts any duty or liability to a customer which ANZBGL may have under the UK Financial Services and Markets Act 2000 or under the regulatory system as defined in the Rules of the FSA. This document is issued on the basis that it is only for the information of the particular person to whom it is provided. This document may not be reproduced, distributed or published by any recipient for any purpose. This document does not take into account your personal needs and financial circumstances. Under no circumstances is this document to be used or considered as an offer to sell, or a solicitation of an offer to buy. In addition, from time to time ANZBGL, ANZ NZ, ANZ S, their affiliated companies, or their respective associates and employees may have an interest in any financial products (as defined by the Australian Corporations Act 2001), securities or other investments, directly or indirectly the subject of this document (and may receive commissions or other remuneration in relation to the sale of such financial products, securities or other investments), or may perform services for, or solicit business from, any company the subject of this document. If you have been referred to ANZBGL, ANZ NZ, ANZ S or their affiliated companies by any person, that person may receive a benefit in respect of any transactions effected on your behalf, details of which will be available upon request. The information herein has been obtained from, and any opinions herein are based upon, sources believed reliable. The views expressed in this document accurately reflect the author s personal views, including those about any and all of the securities and issuers referred to herein. The author however makes no representation as to its accuracy or completeness and the information should not be relied upon as such. All opinions and estimates herein reflect the author s judgement on the date of this document and are subject to change without notice. No part of the author's compensation was, is or will directly or indirectly relate to specific recommendations or views expressed about any securities or issuers in this document. ANZBGL, ANZ NZ, ANZ S, their affiliated companies, their respective directors, officers, and employees disclaim any responsibility, and shall not be liable, for any loss, damage, claim, liability, proceedings, cost or expense ( Liability ) arising directly or indirectly (and whether in tort (including negligence), contract, equity or otherwise) out of or in connection with the contents of and/or any omissions from this communication except where a Liability is made non-excludable by legislation. Where the recipient of this publication conducts a business, the provisions of the Consumer Guarantees Act 1993 (NZ) shall not apply. Page 6 Economics@ANZ