Prepare for a parity party

Updated September 29, 2010 11:55:12

Foreign exchange markets spend a lot of time getting excited about big round numbers, and nothing comes bigger than 1:1, or parity.

When the euro fell beneath parity with the US$ back in January 2000 the 'infant' currency was derided by the popular press in Europe as a failure and it took over two years to reclaim that critical psychological level.

However recover it did and EUR/USD now sits on the cusp of 1.50 versus the dollar. The same can be said for the Canadian dollar versus the US$.

In September 2007, the Canadian dollar surged through parity with the US$ and kept on going to touch 1.10 in November of 2007. Ultimately, however, the Canadian dollar parity party proved very short lived. As the global financial crises (GFC) took hold through the second half of 2008, the C$ slumped below 0.70 versus the US$.

While it has since recovered a good deal of ground, it still sits beneath the all important parity level with the US.

Australia came close to a parity party last year. With 1.00 very much in its sights versus the US$, the A$ hit a post float record high of 0.9849 in July of last year. But the tables, chairs, balloons and party hats were quickly put back in the boxes as the GFC took hold and the A$ slid through the fourth quarter last year to all but touch 0.60 versus the dollar.

Parity parties have a habit of being called, but not actually taking place!

So why is parity so important?

Derivative traders spend a lot of time constructing complex structures with 'payoffs' being generated if big levels are hit, so the prospect of a parity party for the Australian dollar is like 'Christmas in July'. The financial press also loves big psychological levels.

A quick check on Google News Archives for "Australian dollar & parity" stories shows a very sharp rise in headlines through October 2007 and then again in May of last year, September of this year saw quite a smart rise in headlines and more of the same in October. Bottom line, parity sells press so expect to read a lot more about it.

So who gains from a stronger currency?

Importers like currency strength and so too do holidaymakers. Google Insights tells us that Australian resident 'hits' on "New York as a holiday destination" reached the highest level seen in the last five years in July and remain at very elevated levels. A strong currency sells foreign travel.

But Iit's not all about winners. Clearly the export community is hurt by a strong currency and if the Australian dollar was indeed to hit parity and beyond as some are beginning to think, the impact could indeed be significant. Perhaps there is an argument to suggest that the Australian economy is becoming more resilient or immune to currency strength.

In the past year, iron ore and coal accounted for 38 per cent of Australia's exports. If you widen the spectrum to oil, gas and metals and ores etc, commodity exports are 55 per cent of exports.

Back in late 1999, this number was closer to 28 per cent. Given that these are traded and priced in US$, it seems fair to argue that the impact of a rapid move higher in the Australian dollar now on the export sector will be less aggressive than it might have been late last decade.

To be sure, it will be painful especially for the agricultural sector. However in a net sense, the Australian economy has massively leveraged into growth in Asia and benefited from a tremendous rise in commodity exports. That will tend to 'shield' significant parts of the economy from the harsh impact of a stronger currency.

So now for the big question - will we get there? There is no way of knowing with any confidence. But there are a number of solid arguments to suggest that now, more than ever, the risks lie in that direction. US$ three month libor rates sit at just 0.28 per cent. The equivalent in Japan is 0.34 per cent.

In effect, the US$ has replaced the ¥ as the quintessential 'funding currency' - that is the currency that you can sell to buy higher yielding currencies like the Australian or New Zealand dollar. Bond yields are clearly moving in favour of the Australian dollar. Ten year Australian Government bonds currently offer some two per cent more than equivalent yields in the US.

Three year swap rates are 3.2 per cent higher than the average equivalent in the US, Europe and Japan. These rates are some of the most attractive seen since the first half of last year. Commodity markets are doing well and global equity markets have seen solid gains with Asian markets seeing tremendous inflow.

Indeed, through 2009, an incredible US$46bn was funnelled into equity markets in Korea, India and Taiwan by foreign investors. Record equity inflow was also seen in Australia in that period. Net equity inflow in the year to June touched a fresh record of A$44bn.

While much of the recent move higher in the A$ was arguably due to domestic factors, the key driver however has to be the US dollar. As financial markets went into melt down mid last year, investors dived into the US dollar as a 'safe haven'.

Now that investors are more confident on the recovery, the US dollar is being dumped. Between July of last year and March of this, the 'big' dollar gained some 25 per cent in value versus major currencies. Since then it has fallen 16 per cent, with many talking about a lot more to come.

Given the Federal Reserve is not expected to raise rates until late next year at the earliest, it is certainly very feasible that the US dollar falls further - and were the US dollar to push back through the lows seen early last year, parity for the Australian dollar would be just a matter of time.

Perhaps last year's parity party wasn't actually cancelled, but merely postponed.


First posted October 16, 2009 15:30:00