Currency forecasts and trading strategy: AUD relative to USD, EUR and

GBP
Section 1.0 Introduction and Background
This report considers various methods of forecasting future currency exchange
rates with the aim of producing a summary forecast for three currency pairs;
AUD/USD, AUD EUR and AUD GBP. The relevant period covered by the forecasts
is the 12 months up to 27 April 2016.
Also included is a section on trading strategy based on the summary forecasts
derived. This section provides a recommended allocation of AU$10,000,000 into
AUD, USD, EUR and GBP with an aim of producing a profit. All currencies are
assumed to remain free-floating over the forecast period.
The Spot Rates assumed as the basis for this report are summarised in figure 1.
Figure 1: Spot Exchange Rates
Quote
Spot @ 17/04/2015
AUD/USD
AUD/EUR
AUD/GBP

0.7600
0.7200
0.5100

Currency Unit
USD
EUR
GBP

Section 2.0 Exchange Rate Forecasts: AUD relative to USD, EUR and GBP
to 27 April 2016
Section 2.1 Parity Conditions Approach Derived Forecasts
Section 2.1.1 Inflation Expectations and Exchange Rate Implications
Figure 2 summarises expectations-based forecasts for inflation in the USA, UK,
Euro area and Australia over the next 12 months:
Figure 2: Inflation Expectations
1 Year Inflation Expectations
Relative Inflation
Year:
2016 Factor
Quarte
r:
To Q1.5
Austral
2.50%
100.0000%
ia
USA
2.00%
100.4902%
Euro
GBP

1.25%
0.90%

101.2346%
101.5857%

Forecast Ex.
Rate
1.0000
0.7563
0.7112
0.5020

Quote
AUD/AU
D
AUD/US
D
AUD/GB
P
AUD/EU
R

Change
(%)

Note
s

0.0000%
-0.4902%
-1.2346%

(1)
(2)
(3)

-1.5857%

The Relative Inflation Factor and Indicated Forward Rate column figures have
been calculated according to the Relative Purchasing Power Parity method for
forecasting changes in future spot exchange rates. The Australian Dollar is
forecast to decline moderately against the USD, GBP and EUR.

(4)

Section 2.1.2 Interest Rate Expectations and Exchange Rate

Implications
Figure 3 summarises interest rates available on debt securities in the USA, UK,
Euro area and Australia, maturing in 12 months.
(1) Calculated as the average of RBA Market economists' inflation expectations 1-year ahead expectation to
Q4 2015 and Q2 2016. Data sourced from http://www.rba.gov.au/statistics/tables/index.html#inflationexpectations.
(2) Derived from the minutes of the FOMC March 12-18, 2015. These meeting minutes can be accessed at
http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20150318.pdf.
(3) Derived from information in the BOE inflation Report, February 2015. The report can be accessed at
http://www.bankofengland.co.uk/publications/PublishingImages/inflationreport/cpimktfeb15.gif.
(4) Calculated as the average of the 2015 Q1 and Q2 One Year Ahead figures made available online by the ECB.
These figures can be accessed at

Figure 3: Interest Rates

1 Year Interest Rates
Relative Interest
Year:
2016 Rate Factor
Quarte
r:
To Q1.5
Austral
2.0750
100.0000%
ia
%
0.2300
100.8408%
USA
%
0.3345
101.7347%
Euro
%102.3770%
GBP
0.2950

Forecast Ex.
Rate
1.0000
0.7537
0.7077
0.4982

Quote
AUD/AU
D
AUD/US
D
AUD/GB
P
AUD/EU
R

Change
(%)

Note
s

0.0000%
-0.8408%
-1.7347%
-2.3770%

(1)
(2)
(3)
(4)

The Relative Interest Rate Factor and Indicated Forward Rate column figures have
been calculated according to the Interest Rate Parity method for forecasting
changes in future spot exchange rates.
The Australian Dollar is forecast to decline moderately against each currency
considered.
Section 2.1.3 Economic Growth Expectations and Exchange Rate
Implications
Figure 4 summarises forecast for GDP growth rates, during 2015 and 2016, in
each of the countries or regions considered in this analysis.
Figure 4: GDP Growth Forecasts (1 Year)
Year:
Country / Region
Australia
USA
Euro area
UK

2015-2016
Growth Rate
3.0000%
3.0000%
1.7000%
2.5000%

GDP growth is expected to be higher in Australia than in the UK and Euro area,
and about that same as in the USA. An analysis of the impact of these forecasts
is included in Section 2.4 of this report.
Based on a desktop analysis of these figures, all else remaining unchanged, the
AUD/USD exchange rate should remain stable, while the AUD should appreciate
moderately relative to both the GBP and EUR.

Section 2.2 Balance of Payments and Flow of Funds Approach Derived

Forecasts
Section 2.2.1 Balance of Payments Expectations and Exchange Rate
Implications
Under Balance of Payments assumptions, changes in the AUD exchange rate are
forecast to be most pronounced relative to the USD, given Australias position as
a net importer and the role of the USD in international trade facilitation. This
forecast should be considered in the context of falling commodities prices
globally, particularly the significant falls in the prices of oil and iron ore (RBA

Statement on Monetary Policy, February 2015). Iron ore represents a significant

component of Australian exports, and falls in the price of this commodity are
likely to exert a negative influence on the demand for AUD over the forecast
period. Increases in the volumes of bulk commodities exported could negate
some or all of this influence.
On balance, it seems likely that the effect of changes in commodities prices on
the AUD/USD exchange rate will be negative. Existing domestic stocks of USD
could prove to be a supportive mitigating factor for the AUD/USD exchange rate
over the forecasting period. The extent to which this might be a factor is not
entirely clear.
The fall in the prices of gold and thermal coal should exert a negative influence
on the AUD/GBP and AUD/EUR exchange rates. Changes in consumer
preferences, for example changes in the demand for German manufactured
motor vehicles in Australia, may also be influential however such changes are
harder to predict.
Section 2.2.2 Foreign Direct Investment and Exchange Rate Implications
Investment in the energy and natural resources extraction sector is forecast to
continue declining sharply over the forecast period (RBA Statement on Monetary
Policy, February 2015). This will be a significant detractor to the quantum of
inward foreign direct investment flows and is likely to be most influential on the
AUD/USD exchange rate given the role of USD as the primary currency for global
trade facilitation. Overall, the general trend of Foreign Direct Investment Flows is
likely to be reducing over the forecast period, meaning a reducing demand for
AUD and a resulting devaluation, all else remaining unchanged.

Section 2.3 Asset Market Approach Derived Forecasts

Section 2.3.1 Asset Markets Themes and Implications for Exchange
Rates
The relative attractiveness of the returns available on interest rate and other
financial assets is likely to be maintained or enhanced significantly relative to the
EUR as a result of the aggressive policy actions taken by the ECB in recent
months. This has resulted in a marked compression in yields on interest rate
securities within the Eurozone, particularly on government issued debt. In some
recent instances bonds have been issued with a negative yield to maturity. The
returns available on high-rated Australian interest rate securities are particularly
attractive in this environment, as evidenced by the net capital inflows relating to
the public sector in recent months. This state of affairs is expected to hold over
the forecast period, providing positive support for the AUD against both the GBP
and EUR.

Section 2.4 Forward Exchange Rates

Forward exchange rates should theoretically be equal to the spot exchange rate
prevailing at the forward date. The following forward exchange rates were
quoted at the time of writing this report:
Figure 5: Forward Exchange Rates (1 Year)
Currency Pair
Forward Rate*
0.763
AUD/USD
8
0.701
AUD/EUR
1
0.508
AUD/GBP
1

Spot Rate

Premium / (Discount)

0.7600

0.5000%

0.7200

-2.6250%

0.5100

-0.3725%

Based on the quoted forward exchange rates, the AUD is forecast to appreciate
against the USD, and depreciate relative to the GBP and EUR.

Section 2.5 Summary Forecasts

Forecasts derived under parity conditions assumptions suggest that the AUD will
decline moderately against both the USD and GBP. However, it is less clear as to
how the AUD will perform against the EUR, and the GBP to a lesser extent. If
Interest Rate Parity holds, the AUD should depreciate against the EUR and GBP.
Inflation expectations also point to a depreciation of the AUD against the EUR.
However, the forecast for economic growth in Australia is much higher than that
forecast for the Euro area, and somewhat higher than that for the UK, suggesting
an appreciation of the AUD.
It may be useful to consider Parity Conditions assumptions against the backdrop
of the unconventional monetary policies currently being pursued by central
banks in the UK and Euro area. These policies act to both increase the monetary
base and reduce interest rates in their respective markets. In each case, one of
the aims of these unconventional central bank interventions in markets is to lift
the rate of inflation within their national or regional economies. If successful,
both the reduction in interest rates and increase in inflation should theoretically
act to weaken the respective national or regional currencies. The extent to which
these central bank interventions are successful remains to be seen, however
current expectations are that both inflation and interest rates will remain low
relative to those expected domestically.
Contrasting with this is the recent cessation of the use of unconventional
monetary policy by the US Federal Reserve Bank. While interest rates on risk free
instruments remain relatively low in the USA, there is significant uncertainty
around the anticipated tightening of monetary policy. Recent minutes of Federal
Open Market Committee meetings indicate that any such tightening should be
linked to an increase in the rate of domestic inflation and economic growth.
Should inflation be dominated by an increase in the general economic prospects
for the USA, the USD would be expected to appreciate against the AUD.

Furthermore, an increase in interest rates for USD denominated assets may

result in an appreciation in the USD against other currencies, consistent with the
outcomes expected under Asset Markets assumptions. While interest rates on US
government obligations with maturities due in one year do not reflect
expectations of a tightening of monetary policy, such a possibility should form
part of the considerations in devising a speculative trading strategy. Asset
Markets assumptions suggest an appreciation of the AUD relative to both the
GBP and EUR.
Balance of Payments and flow of funds forecasts are indicative of a depreciating
AUD against the USD, while changes against the GBP and Euro are likely to be
benign.
Forward exchange rates suggest a moderate appreciation of the AUD against the
USD, and a depreciation relative to the GBP and EUR.
Considering the mix of factors which are likely influence exchange rates over the
forecast period, summary forecasts have been developed and are included in
Figure 6.
Figure 6: Forward Exchange Rates (1 Year)
Currency Pair
Summary Forecast
0.752
AUD/USD
5
0.702
AUD/EUR
4
0.507
AUD/GBP
5

Spot Rate

Premium / (Discount)

0.7600

-1.0000%

0.7200

-2.0000%

0.5100

-0.5000%

These forecasts are made anticipating that the Federal Reserve Bank will tighten
monetary policy sooner rather than later in an attempt to normalise the
general level of interest rates in the US, and that economic growth and inflation
will remain low in both the UK and Euro area.
Commodity prices are assumed to remain depressed, while investment in the
resources sector will decline significantly. Yields on domestic interest rates
securities and other financial instruments should remain attractive in relative
terms, particularly in an environment of central bank intervention in financial
markets within Europe and the UK. The return on financial assets is assumed to
be a mitigating factor over the forecast period.

Section 3.0 Currency Trading Strategy to 27 April 2016

Based on the summary forecasts, the initial capital available for the
implementation of a trading strategy will allocated as follows:
USD Allocation: 60 per cent of the funds available to implement the trading
strategy will be allocated to USD related transactions. This portion of the initial
capital will then be invested at the domestic rate of 2.0750% for 12 months, with
the proceeds bought forward at the forward exchange rate of AUD 1 =USD

0.7638. At the end of the forecast period the funds will be used to purchase USD
at the arranged forward exchange rate and immediately sold at the forecast spot
exchange rate of AUD 1 = 0.7525. The net profit from this part of the strategy is
forecast to be approximately AUD 216,469.
EUR Allocation: 40 per cent of the funds available to implement the trading
strategy will be converted at the spot exchange rate of AUD 1 = EUR 0.72 and
invested for one year at a rate of 0.3345%. The proceeds expected from these
transactions will be sold forward at the rate of AUD 1 = EUR 0.7011. Once
converted back to AUD at the end of the forecast period, it is expected that the
net profit from this part of the strategy should total approximately AUD 121,571.
GBP Allocation: No portion of the funds available for the execution of a trading
strategy will be allocated to GBP related transactions as the forecast profit
opportunities are relatively unattractive.
Section 3.3 Trading Strategy Risk Management
While the USD allocation is relatively more attractive, 30 per cent of the funds
will be allocated to EUR related transactions. This provides at least some level of
diversification, however it should be noted at the outset that the level of risk
reduction from this strategy, if any, is unclear.
Furthermore, should the forecasts contained in this report prove to be incorrect,
the proposed trading strategy may not deliver the profits as calculated, or may
even result in a loss of capital.