The Australian Dollar touched 7-month lows versus the US Dollar late in 2016 while achieving a 3-month low against the dog of 2016 - the Pound.

It hit 6-month lows versus the Canadian dollar and 3 ½ month lows versus the New Zealand Dollar.

"That leaves the A$ looking increasingly ‘cheap’ on a range of crosses to us even after a rebound in the last few days," says analyst Richard Rennie at Westpac in Sydney in a note to clients seen by Pound Sterling Live.

So if the Australian Dollar is already cheap, will it recover to more balanced valuations?

Yes, argue Westpac.

"We see three reasons to support our less downbeat view. It is cheap on a range of fitted fair value models; the beneficial commodity story is underpriced and global/Asian growth accelerated into the end of 2016," says Rennie.

The current commodity story is believed to be more positive than many in the market believe.

Commodity prices including iron ore, coking and thermal coal rose appreciably last year, and while coking prices have retraced a reasonable part of the four month rally in the last 4 weeks, prices remain high by recent standards.

Iron ore is close to 2 year highs; thermal coal close to 3 ½ year highs; coking coal hit 5 year highs late last year and even (floating rate) LNG prices finished last year at 18 month highs after hitting 8 year lows early in the year.

"Commodity prices rose noticeably over the course of last year, reflecting both stronger demand and supply shocks in China and other countries. This story is set to continue even after today's much better trade data," says Rennie.

Furthermore, Westpac are aware of the improving global growth picture which should help the AUD.

"The last round of regional and indeed global PMI’s confirmed a pretty clear message. That message is that the global economy fared much better than most expected last year despite the long list of economic and geopolitical events that were ‘thrown in front of the wheels’", says Rennie.

Aussie Rates Today for Reference (7-1-17): Australian to US Dollar exchange rate: 0.7298Pound to Australian Dollar exchange rate: 1.6848

Euro to Australian Dollar exchange rate:1.4443Note the above are spot market quotes; your bank will affix a spread to the rate. To get closer to the market and secure up to 5% more currency we suggest engaging an independent specialist.

Risks are Biased to a Weaker Australian Dollar in 2017

Westpac see the Australian to US Dollar exchange rate pushing above 0.74 (the 50 day moving average at 0.7420) and possibly towards 0.75 this quarter.

However, beyond that analysts have strong doubts over the sustainability of Aussie strength.

Westpac is forecasting two rate hikes from the Fed this year and no change from the RBA; the Fed 'dot plots' suggested risks of more.

Thus, as we move through 2017, interest rate differentials will likely be increasingly less supportive for the Australian Dollar.

"While the positive commodity story is under-priced, commodity prices will soften as 2017 progresses. Thus as we move through the year, our fair value models will be falling," says Rennie.

However, Westpac believe the biggest risk of all appears to be the geopolitical recession or near vacuum that we may face in 2017:

The combination of a likely much more inward looking US administration; a UK administration that will spend significant time agonising over Brexit;

a Europe forced to hold its breath through Dutch, French and German elections;

and China focussed on the all-important 19th Party Congress in the fall arguably renders the worlds geopolitical architecture volatile at best.

"Throw in increased risks surrounding Russia’s position in the Middle East, North Korean risks etc. and it becomes easy to understand why the A$ will remain a 'go to liquid risk proxy'. Then overlay a keen sense that we may be just one tweet away from a China/ US trade spat and we would argue that strength in the Australian Dollar should be strongly capped," says Rennie.

Westpac believe the flipside of this is the risk that President Trump forges a more unilateral path towards geopolitics allowing the benefits of US fiscal policy and super low rates elsewhere to boost global reflation and thus the Australian Dollar.

"With Obama’s last official speech Tuesday next week / Trump’s first general news conference Wednesday, next week should give us a clearer sense of whether the A$ really is cheap to fair value, or just one tweet away from another tumble. Whatever the outcome, if we are correct and AUD is cheap, gains should be firmly capped closer to 0.75," says Rennie.

Deutsche Bank see AUD Near Fair Value

According to the latest currency valuation studies carried out by Deutsche Bank the Aussie is actually close to fair-value.

The Chart below shows whether currencies actual value is more or less than the value calculated by various valuation models:

When the actual value is above that estimated by the model it indicates the currency is overvalued; when below undervalued.

Analysts use these models to determine which direction the currency is likely to go in next.

When overvalued versus a model it may indicate the currency is more likely to fall towards the model’s estimate – or ‘fair value’ as it is called – when below it signals the currency is likely to appreciate towards fair value in the future.

Deutsche’s chart shows several common valuation models including DBeer (nothing to do with Diamonds), FEER and PPP.

DBeer is based on economic variables, the FEER focuses on the Current Account Balance and Employment, and the PPP is the exchange rate calculated according to the value of the same basket of goods in countries with different currencies such that the ‘fair value’ exchange rate is that at which the two baskets of goods equal the same value.

As can be noted, the Aussie is not as undervalued according to Deutsche’s valuations – in fact it is in the top one-third of currencies according to Valuations Ranked ‘spiral’.

It is also overvalued according to FEER.

This seems to indicate Westpac Rennie’s premise that the Aussie is very undervalued is not quite accurate.

It is probably explained by the fact that Westpac are using their own bespoke valuation models which are different to those used by Deutsche.