Part 1 - Commentary & Forecasting of the Australian Dollar
Introduction
Explaining exchange rates and their direction for the future is often taught as a process. However, when one puts the theory into practice it can be seen as more of an art than a science. Long term exchange rates normally tend to international parity conditions. However it can be seen in the short term that much volatility is a response to economic variables as well as social and political events.
This paper aims to build upon this idea that short term exchange rate fluctuations are much harder to predict and variables other than international parity conditions are responsible for changes.
During a studied 5 week period, from 28th of July to 29th of August 2008, the Australian dollar experienced an extended, dramatic depreciation. From a framework utilised we understand the main levers for change have been:
- Market expectation of lower domestic interest rates as well as overall market sentiment
- Falling commodity prices in many of Australia’s major exports.
- Credit strains, particularly related to the health of the US financial system.
A rate cut, which would be the first in seven years, would diminish some of the Australian dollar’s high-yield appeal. Australia's cash rate was at a 12-year high of 7.25%, while it was 2% in the US. The Australian dollar benefited from this large difference in rates, as investors bought the local unit to take advantage of the nation's higher interest yields.
But the tide turned as investors, especially Japanese retail investors, unwound those leveraged positions amid speculation of steep domestic rate cuts.
The chart below shows the USD- AUD relationship from 28th July to 1st September 2008.
American Dollars to 1 AUD 
Source: X-rates. “Exchange Rates Graph”
The Aussie dollar tends to move in line with commodity prices because of their importance as national exports. This relationship was clearly illustrated for the studied five week period. The chart that follows shows the Reuters/Jefferies CRB Index (the most widely recognized measure of global commodities markets). Many of the weekly discussions that follow in this paper will refer to this chart.
Source: Reuters/Jefferies CRB Index (28th July- 29th August 2008)
JP Morgan chief economist, Stephen Walters, said the weak outlook for commodities was supported by a slowing in world economies, already weakened by collapsing housing and debt markets (Simon Santow 2008).
The following provides a weekly discussion of the performance of the Australian dollar against the US dollar.
Weekly Commentary
Week 1(28th July-1st August)
| Date |
USD/AUD |
Change |
| 28/07/08 |
0.9541 |
↓ 0.0043 |
| 29/07/08 |
0.9583 |
↑ 0.0042 |
| 30/07/08 |
0.9478 |
↓ 0.0105 |
| 31/07/08 |
0.9434 |
↓ 0.0044 |
| 01/08/08 |
0.9374 |
↓ 0.0060 |
The Australian dollar sank to its lowest since mid-May during this first studied week, driven first by firming odds of a cut to interest rates, and plunging commodity prices. Just two weeks after reaching a post-float record above US98c, the dollar sagged to US93.74c at the week's close in Sydney, as domestic and offshore evidence of a sharp economic downturn piled up.
The AUD/USD broke below the 55-day moving average support the previous weekend and remained soft in Monday’s trading partly because of local banking sector concerns with an unanticipated rise in bad loans. Despite a long-term slowing on many indicators, Wednesday’s news that home building approvals dropped for the second consecutive month, and Thursday's news that retailers had their slowest month, in Australia, in seven years in June was a big wake-up call for money markets (Easy Forex, 2008). On Friday, the Aussie extended the past week's loss to 2.9 percent after PricewaterhouseCoopers and the Australian Industry Group said in Canberra the performance of its manufacturing index fell to 46.9 in July, the lowest since November 2005. (Harui and Zachariahs, 2008)
Further weighing on the dollar, commodities came off the boil, with oil dropping 18 per cent in the last three weeks (CRB index). Besides oil, the CRB index, as can be seen from the chart on the previous page, dropped 10 per cent in the previous month, its sharpest fall in 28 years.
Here’s a look at oil pricing from the 28th of July to the 29th of August in US dollars.
Source: Reuters/Jefferies CRB Index (June- August 2008)
Week 2 (4th- 11th August)
| Date |
USD/AUD |
Change |
| 04/08/08 |
0.9320 |
↓ 0.0054 |
| 05/08/08 |
0.9221 |
↓ 0.0099 |
| 06/08/08 |
0.9179 |
↓ 0.0042 |
| 07/08/08 |
0.9109 |
↓ 0.0070 |
| 08/08/08 |
0.8953 |
↓ 0.0156 |
During this studied week the Aussie dropped to its lowest in 6 months against a resurgent US currency as investors continued to sell the Australian dollar with expectations of steep interest rate cuts in the coming months (Easy Forex, 2008). The Aussie’s poor form throughout the week was attributed to falls in commodity prices and speculation of an aggressive rate cut by the Reserve Bank in the following month.
By the Wednesday, the dollar fell to near its four months low, and similarly on the Thursday even though stronger-than-expected job growth in July was reported (Easy-Forex, 2008). This however was overshadowed by the worry of fall in interest rates anticipated by investors. By the end of the week the Aussie had dropped to its lowest in 6 months finishing at $0.8953 against the US dollar having lost more than 10% since it reached a 25-year high of $0.9851 in mid-July.
Week 3 (11th-15th August)
| Date |
USD/AUD |
Change |
| 11/08/08 |
0.8855 |
↓ 0.098 |
| 12/08/08 |
0.8741 |
↓ 0.0114 |
| 13/08/08 |
0.8656 |
↓ 0.0085 |
| 14/08/08 |
0.8703 |
↑ 0.0047 |
| 15/08/08 |
0.8639 |
↓ 0.0091 |
Following on from the previous week the Australian dollar continued its decline from its 25 year high ($0.9851 in mid-July 2008) amid expectations of interest rate cuts by the RBA and softer commodity prices due to worries about the global economic slowdown. The majority of fluctuations for the week revolved around these two issues. The Monday and Tuesday declines can be attributed to the resurgent US Dollar pulling down commodity prices and due to worries of a global economic slowdown affecting commodity prices particularly gold, metal and oil (ABC Net, 2008).
In contrast, the Thursday saw a rise in commodity prices helping the improvement of the Australian dollar. However the positive movement was weakened due to the Reserve Bank giving signals of a rate decrease in September 2008. At this time the 7.25% cash rate was at a 12 year high, however with strong signals of a steep decline investors were hesitant reducing consumer confidence in the Australian dollar.
Again, commodity prices fell amid continual speculation of a rate cut caused the Australian dollar to finish around the 7 month lows at $0.8639 against a buoyant US Dollar (CRB Index, 2008).
Week 4 (18th- 22nd August)
| Date |
USD/AUD |
Change |
| 18/08/08 |
0.8737 |
↑ 0.0098 |
| 19/08/08 |
0.8675 |
↓ 0.0062 |
| 20/08/08 |
0.8721 |
↑ 0.0046 |
| 21/08/08 |
0.8729 |
↑ 0.0008 |
| 22/08/08 |
0.8803 |
↑ 0.0074 |
Starting the week strong, the Australian dollar rose from a 7 month low. This was largely due to a jump in commodity prices which rebounded from the previous week’s lows, most notably gold, metal and crude oil, with an increase in demand from Asian markets.
Investors however were still wary of the 12 percent loss since mid July while waiting for the release of the Reserve Bank Monetary policy (FatCat.com.au, 28th July 2008). With the expected 25 basis points reduction in Australia’s official cash rate in September, and growing support for the US dollar, the Australian dollar fell slightly. This projected interest rate cut would be the first in seven years, with some analysts believing it would reduce the high yield allure which allowed the Australian dollar to reach its high in mid July this year (2008).
Interestingly, Joseph Capurso of CBA suggested that more emphasis needs to be placed on commodity pricing to bolster the currency in the near term. (The Sydney Morning Herald, 26th August 2008). With the CRB commodities index increasing by 3.7% on the Thursday, the Australian dollar held near a 10 day high of $US.8815. Week 5 (25th- 29th August)
| Date |
USD/AUD |
Change |
| 25/08/08 |
0.8633 |
↓ 0.0170 |
| 26/08/08 |
0.8580 |
↓ 0.0053 |
| 27/08/08 |
0.8583 |
↑ 0.0003 |
| 28/08/08 |
0.8671 |
↑ 0.0088 |
| 29/08/08 |
0.8639 |
↓ 0.0032 |
By 4:10pm on Monday 25th of August, the Australian dollar was at $0.8640 against a firm U.S. dollar, down 1.7% from the previous Friday. This was due to the weaker commodity prices which continued to worry investors along with the suspicion of a slowing global economy. Also intensifying this effect were the declining prices of oil, gold and metal.
Australia is a large exporter of natural resources and the Australian Dollar had been sold assertively (increasing supply and lowering price) in recent weeks as investors unwound the once common short U.S. dollar and long commodities trade. By the studied Tuesday the Australian dollar extended further losses against the U.S. currency, as new financial sector anguish prompted investors to sell riskier assets and high yielding currencies. It fell as far as $0.8564, the lowest since January 22 2008. The failure of the Columbian Bank, the ninth U.S. bank to fail in 2008, reminded investors that the global credit crunch is still being felt and pulled stock markets lower.
The Australian dollar pulled away from an eleven month low on the Wednesday of this studied week, as the U.S. dollar paused in its rally against most major currencies. Higher commodity prices also offered support. However, with domestic interest rates set to be slashed, it was unlikely to sustain the rebound (Easy Forex, 2008).
The Australian dollar climbed to its highest in three days on the Thursday, after strong second-quarter investment data led investors to await a hefty rate cut the following week (the first in seven years). This came since Futures were pricing in 25 basis point cut by the Reserve Bank of Australia. Higher gold prices and a weaker U.S. dollar also supported the Thursday soar.
The week drew to a close as expected, with the Australian dollar easing to $0.8622 as its U.S. counterpart benefited from unexpectedly positive economic news.
Forecasting Approaches
There are many types of forecasting used in practise including market based forecasting, technical based forecasting (commonly known as technical analysis) and fundamental forecasting (commonly known as fundamental analysis).
Market based forecasting:
E [Std/f] = S0d/f [(1+ pd)/(1+ pf)]t - this formula is used to predict the relative purchasing power parity for our forecast below. E [Std/f] = S0d/f [(1+ id)/(1+ if)]t - this formula is used to predict the interest parity below. Using the above formulas exchange rates can be forecasted assuming international parity conditions. These formulas’s also have the key advantage that anyone with access to a financial newspaper can apply them. Academics have found as the forecasting intervals lengthen these formulas become more accurate, (Butler. 2004). The table below shows the results of using the market based forecasting formula’s to predict exchange rates in the next two weeks.
The inflation rate for the USA is 5.60% and in Australia is 4.50% in the period focused on in this paper. The interest rate in USA is 2.00% and in Australia is 7.25%, in the period focused on in this paper
Technical based forecasting
This is the use of past price patterns to forecast exchange rates. The majority of forecasters add value for their clients by supplementing this type of forecasting with market-based forecasts. Academic literature often dismisses technical forecasting despite a London based foreign exchange survey finding 90% of dealers placed some weight on technical forecasting (Taylor and Allen, 1992). According to the Wall Street Journal Europe, whether technical analysis is really useful is a matter of some dispute on Wall Street. Some investors believe that it is impossible to forecast the market's ups and downs. Academic studies have shown that when most people, professionals and amateurs alike, try to move money in and out of stocks to beat market fluctuations, they tend to wind up with losses" (Wall Street Journal 30th July 2007).
Fundamental forecasting:
This is the use of economic data to forecast long term exchange rates. Data used includes balance of payments, money supply, industrial production and consumer confidence. However due to exchange rates reacting to new information and often responding with a lag to economic variables this data is often used to forecast over the long-term.
Future Outlook
If the weakening of commodity prices continues (as has occurred), this will diminish the demand for the Australian dollar. Australia is a major exporter of coal, iron ore, gold, aluminium and other minerals. If export prices fall, there is less demand for the Aussie, putting downward pressure on the exchange rate. Several key business activity indexes further suggested that a slowdown in the global economy was likely, further diminishing demand for exports and hence the Aussie dollar. Therefore it is likely that international parity forecasts will not hold in the short term, as previously suggested and the exchange rate would most likely fall.
Conclusion
Our observation over the studied five week period has been marked by considerable financial changes. We saw fundamental economic performance and parity conditions play a role in exchange rate movements. However, daily fluctuations were mainly driven by market responses to public information released and the latest development in energy and commodity markets.
Our fundamental analysis of relative purchasing power and interest rate differentials suggests the movement will hardly be volatile. However, as previously stated, the majority of the volatility arises over expectations and market sentiment making it much harder to predict. Part 2 - Analysis of Forecasting
Introduction
This part of the paper will review the movements of the Australian dollar relative to the US dollar over the forecast period of 1st to 12th September 2008. It will compare the data to our original forecast in Part I, explaining the forecasting errors for each method of forecasting. This will then show practically the shortcomings of using market based forecasting to predict short term volatility of exchange rates, whilst showing other factors such as market expectations, commodity prices and credit strains are considered more of a lever for change in the short term. Academic theories and methods used in practise are also analysed to evaluate which methods provide the most accurate and reliable results in determining changes in exchange rates.
The graph below shows the actual movements of the Australian dollar over the forecasted period, seeing the dollar begin at 0.8537 (1st September 2008) and falling to 0.8048 (12th September 2008)
Figure- 1. Actual Spot Rates from 1st – 12th September 2008. Source: RBA.
Forecasting Approaches in Practise
The various forecasting approaches overviewed in Part 1 of this paper have varying degrees of utility as predictive tools in practise.
Market-based forecasting
The results show international parity conditions are useful for forecasting long-term trends in nominal exchange rates. However, they are less helpful in forecasting real exchange rates because real exchange rates are assumed to be constant in the international parity conditions (Table 1).
| |
Forecast |
Forecasting Error |
| Date |
Actual Spot Rates |
IRP |
RPPP |
IRP |
RPPP |
| 1/09/2008 |
0.8537 |
0.8638 |
0.8639 |
-0.0101 |
-0.0102 |
| 2/09/2008 |
0.8465 |
0.8637 |
0.8639 |
-0.0172 |
-0.0174 |
| 3/09/2008 |
0.8254 |
0.8635 |
0.8640 |
-0.0381 |
-0.0386 |
| 4/09/2008 |
0.8335 |
0.8634 |
0.8640 |
-0.0299 |
-0.0305 |
| 5/09/2008 |
0.8164 |
0.8633 |
0.8640 |
-0.0469 |
-0.0476 |
| 8/09/2008 |
0.8349 |
0.8632 |
0.8640 |
-0.0283 |
-0.0291 |
| 9/09/2008 |
0.8050 |
0.8631 |
0.8641 |
-0.0581 |
-0.0591 |
| 10/09/2008 |
0.8065 |
0.8630 |
0.8641 |
-0.0565 |
-0.0576 |
| 11/09/2008 |
0.7962 |
0.8628 |
0.8641 |
-0.0666 |
-0.0679 |
| 12/09/2008 |
0.8048 |
0.8627 |
0.8641 |
-0.0579 |
-0.0593 |
Table 1 – Comparison of actual spot rates against forecasted rates. Source: RBA (actual spot rates)
*Rates are quoted in USD/AUD nominal.
Figure 2- Comparison of Actual Spot rates against forecasted rates Source: RBA (actual spot rates)
*Rates are quoted in USD/AUD nominal.
As can been seen in Table 1 and Figure 2, forecasted nominal exchange rates using interest rate parity and relative purchasing power parity were different from the actual spot rates. The actual spot rates dropped gradually from USD 0.8537/ AUD to USD 0.8048/ AUD over the two weeks.
Interest Rate Parity (IRP) forecasting
The forecast based on IRP concluded that the exchange rate will decrease slightly and gradually from USD 0.8638/AUD to USD 0.8627/ AUD during the forecast period.
One of the major reasons for the differences between forecasted and actual exchange rates is because interest rate parity only occurs in “perfect” markets but does not exist in ‘real’ markets. This is because it considers the law of one price, which assumes purchasing power parity holds within the markets (Butler, 2004). This means that if there are no restrictions or costs on moving products between markets then the product’s price should be the same in both markets. However, this is an unrealistic assumption as arbitrage opportunities always exist within the markets. There will always be some difference in the interest rates and exchange rates of different markets, for market speculators to make a profit from (Butler. 2004)
Another major cause for the difference was that the RBA cut its interest rate from 7.25% to 7.00%. The rate cut diminished some of the Aussie's high-yield appeal (RBA, 2008).
Relative Purchasing Power Parity (RPPP) forecasting
The forecast based on RPPP concluded that the exchange rate will increase slightly and gradually from USD0.8639/AUD to USD0.8641/AUD during the forecasting period. This is different than the actual spot rates because neither inflation nor expected future spot rates are traded contracts. Thus this relationship only holds on average. RPPP only holds over the long run and is not very helpful for predicting day-to-day exchange rates.
Review of Future Outlook
In Part I, the paper noted a number of factors that impact the Australian dollar. In making our case, we made a few predictions for the forecast period and here, we analyse the impact these factors have had in our forecasting error. It should also be noted that we forecasted the exchange rate would most likely fall as low as $0.8200-$0.7800 to the USD. This was where the spot rate finished by the 12th of September (our forecast date). However as stated earlier this figure was not derived from a formula or a scientific method but rather using a mixture of past data (technical analysis) and analysing economic variables (fundamental analysis) together. This method is referred to as ‘Fusion analysis’, is used by traders in today’s market, and is proven to be a useful measure to determine the direction of short term volatility (Nakakubo and Okada, 2001)
Commodity Prices
From the first part of the paper we realized that in the studied period on several occasions the Australian dollar was highly correlated with commodity prices. This is again reflected in the forecasted weeks. The paper predicted, considering the global economy slowdown, that commodity prices will fall and with the Australian dollar. This was exactly the case and the relationship can be seen in Figure 3.
Figure- 3. CRB Index and Actual spot rates from 1st – 12th September 2008. Source: Reuters and RBA
Other Factors
Sluggish second quarter gross domestic product (GDP) was another reason for the Australian dollar to depreciate. The weak data convinced investors that another rate cut in Australia would follow in October 2008. As a result investors were selling the Australian dollar.
More of these factors will be discussed in the Weekly Review that follows.
Weekly Review
Week 1 (1st -5th September 2008)
Limited GDP growth reported for the second quarter along with expectations of cautious monetary policy, as the inflation pressure remains high, made the market expect further rate cuts by the RBA and was not helping the future outlook of the Australian economy.
The Australian dollar fell to a one-year low after the RBA delivered its first rate cut in seven years resulting in investors selling their high yielding currency like the AUD on concerns of a global slowdown (Easy Forex, 2008). This was further accentuated by sliding commodity prices (CRB Index, 2008). The new cash rate was 7.00%, a decrease of 25 basis points. The Australian dollar rose above its one year low on the studied Thursday as investors waited for interest rate decisions by the European Central Bank and the Bank of England. They were expected to leave rates unchanged but the market expected rate cuts later in the year which would boost the US dollar. The US dollar was further supported by aggressive unwinding of the long commodities and short US dollar trade due to growing concerns about a global economic slowdown.
Week 2 (8th- 12th September 2008)
The US dollar jumped on the studied Monday after the US government moved to rescue two major mortgage giants Freddie Mac and Fannie Mae (Paulson, 2008). The bailout seemed to boost appetite for riskier assets on the Monday. The Asian stock markets rallied but Australian bond futures tumbled.
On the Tuesday, however, the Australian dollar returned to its one year low as investors quickly returned to worry about the global economic slowdown. An increase of 1.4% in retail sales in Australia did nothing to change expectations that interest rates could be cut further (Easy Forex, 2008).
The worries of the US financial sector continued to plague the markets all throughout the week including Lehman Brothers’ ability to raise capital. As a result, Australian bond futures surged but reports of 1.4% decrease in the CRB Index due to a slide in crude oil pulled the Australian dollar down (CRB index, 2008).
Government data showed employers hired a total of 14,600 more workers in August 2008, triple what was expected. The jobless rate reached a new low of 4.1% which is two percentage points below that in the US. This strong labour market in Australia diminished chances of interest rate cuts as soon as October 2008 (Easy Forex, 2008). However, on the Friday the Australian dollar extended gains as investors sought higher-yielding currencies on speculation that a solution for Lehman Brothers was in sight, easing worries about the health of the US financial sector.
Conclusion
This paper has forecasted using the international parity conditions and realised that they are not the ideal short-term exchange rate indicators. Forecasting errors in these methods are due to more than expected falls in commodity prices, interest rate cuts, poor financial conditions in the USA and the global economic slowdown. Therefore short term forecasting of the Australian dollar relative to the US dollar was more accurate by judging the most recent past data and anticipating future new information that may arise, rather than any specific formula or science.
As previously noted, there is no agreed method of determining short term fluctuations and methods are constantly debated, technical analysis has even been described by Burton Malkiel as "... anathema to the academic world.” (Burton, 2003 pp139,165). However academics do agree that in the long term, international parity conditions will hold, providing an accurate forecast over the long term.
Marc Bacchetto would like to acknowledge the contribution of David Narunsky, Saidur Rahman, Michael Saad and Mohammed Javed Wasef to this paper. |
