Model themes: USD undervalued but not at extremes - Westpac

Analysts at Westpac explained that their model aggressively ups its long USD exposure to 42% from 28% last week ahead of a crucial week for the USD centred around how much of a hawkish bias will be flagged by the FOMC.

Key Quotes:

"We find that the USD is undervalued, both on narrow and broader measures and regardless of the look back period, but the caution is that the USD’s undervaluation has not "ripened" in either magnitude or duration.

We assess valuation using two approaches: a high frequency "narrow" estimate that relies solely on interest rate differentials (using a five year rolling sample) and a longer term estimate that takes into account interest rate differentials, growth differentials, fiscal balances and the terms of trade (using forty-five years of quarterly data).

On the narrow measure, the USD is undervalued by 12% versus 10yr spreads and by a larger 14% versus 2yr spreads. See slide one. That may be meaningful but it is not extreme. The USD index notably defied yield spreads for an extended period from 2002 through 2004, with undervaluation peaking at 25%. That period may prove to be a highly relevant historical analogue – back then yield spreads were trending strongly in the USD’s favour but global growth was on the upswing too and US deficits were widening thanks to tax cuts.

We also estimate long term valuation that takes into account a broader set of fundamental forces: in addition to interest rates we use growth/productivity differentials, the terms of trade and fiscal balances. The empirical data here reveals an inverse relationship between fiscal deficits and the USD, thanks mainly to developments in the 1970s and 1980s. Back then larger deficits coincided with a stronger USD and vice versa. In more recent decades however that relationship has weakened considerably and much of the impact is playing out through a rising term premium – a development that is not always USD positive.

Regardless, the USD appears to be undervalued against a broader set of fundamental forces too, on our measure by around 9% (see slide two). As with our narrower measure however that is not extreme. The USD’s maximum deviation from equilibrium typically ranges somewhere between 10-20%. Over/undershooting cycles have commonly last 2-3 years too whereas in this cycle the USD has only been undervalued for barely six months."