Australian Dollar: The Next to Reach Parity with the US Dollar?

It has been a record breaking past few months in the currency markets. While the EURUSD, the most actively traded pair in the world, made headlines when it surpassed its all time high late September; the story was quickly overshadowed by the Canadian dollar which reached parity with the US dollar. Six months ago, parity still seemed to be a far fetched idea for loonie traders and now, the Canadian dollar is actually stronger than the US dollar. Could the same thing happen to the Australian dollar? Why not? The currency pair is closer to parity now than the Canadian dollar was five months ago. Although it is possible for the Australian dollar to be even with the US dollar, the better question to ask is whether it is probable.

The Australian dollar has already made its mark by rallying over 15 percent in the past eight weeks to a 23-year high against the US dollar. Clear similarities between the Australian and Canadian dollar’s advance could raise expectations that one Australian dollar could soon equal one US dollar. Like Canada, Australia’s economy is rich in natural resources; enjoys a strong economy supported by domestic spending; and has a central bank that is leaning closer towards further hikes than any sort of policy easing.

[B]Australian Dollar Rally Contingent Upon Commodity Strength[/B]
One of the main drivers of Aussie strength has been its correlation with commodity prices. Shipments of raw materials like gold, coal, and iron ore account for nearly 64 percent of total exports. Although this leverages considerable dependence on one volatile sector of the economy, over the last few years, this influence has proved to be one of Australia’s leading sources of growth. With China sustaining double digit growth rates, their demand for commodities have been extremely robust. A modernizing economy requires a greater use of energy and coal accounts for approximately 70 percent of China’s total energy consumption. As the world’s largest exporter of coal, Australia benefits significantly from China’s demand. From an economics stand point, greater demand for these goods translates into bigger revenues for Australian producers, stronger capital spending and higher employment. In addition to coal, prices of gold have also been increasing – Australia is the world’s third largest producer of gold. The correlation between gold prices and AUDUSD can be seen in the graph below. Whether the AUD/USD can make it to parity will be partially dependent upon whether gold will hit $1000 an ounce. With gold trading at a 27 year high, there is no convincing sign that a top is in the making quite yet. Over the third quarter, gold prices climbed 16 percent or approximately $100 an ounce and it is now begging to at least $750…The main reason why gold has been so strong is because people have no faith in the US dollar – they took the greenback down to a record low last month. Gold is seen as the safety net for many investors which means that the uptrend in gold will not give way until the US economy has hit a bottom. Should $750 an ounce in gold prove to be an unsurpassable barrier however, then so will 95 cents in the Australian dollar.

[B]Australian and US Growth Prospects Differ Sharply[/B]
Economic performance is another reason to why the AUDUSD could reach parity sooner rather than later. In the second quarter, the Australian economy grew at an annualized rate of 4.3 which is the strongest pace of growth in 3 years. In response to data, the International Monetary Fund (IMF) raised its forecast for growth for 2007 to 4.4 percent from a much smaller initial forecast of 2.6 percent offered in April. Rising commodity prices, a tight labor market, strong consumer spending and growing business investment have all been big contributors to GDP growth. With their coffers overflowing from export revenue and quickly growing consumer demand within its own boarders, Australian businesses have turned record breaking revenues into investments to keep up with growing demand. This has led to notable surge in capital expenditures. From the most recent GDP breakdown, business investment rose 4.5 percent over the second quarter to add 0.7 percentage points to overall growth. Business and exports aside, the consumer is taking the primary responsibility for growth. Aussie citizens have grown increasingly optimistic as the unemployment rate has been whittled down to a 33-year low of 4.3 percent. For income, the tight labor market has translated into annual wage growth over 3.9 percent since the beginning of 2005. What’s more, recent income tax cuts and lower gasoline prices in August helped to spur increased spending at restaurants. Considering these labor trends and exogenous currents, it is hardly surprising that consumer spending has been a pillar of GDP.
At the same time, the AUD/USD has also been rallying because of deteriorating economic conditions in the US. Although the housing market had been struggling for months, its vulnerability did not come to light until the third quarter. The problems in the credit markets created a snowball affect that was seen across the financial markets, forcing the European Central Bank and the Federal Reserve to pump billions into the financial system. Unsurprisingly, this chain reaction led to a wave of layoffs in the financial sector. America’s biggest mortgage lender Countrywide Financial cut 12,000 jobs. Citigroup warned of 60 percent earnings drop in the third quarter while UBS disclosed $3 billion worth of losses. In the month of August, non-farm payrolls fell by 4k, the first drop in four years. Consumer confidence fell to a 2 year low, driving retail sales excluding autos down 0.4 percent. All of these factors stoked fears that the US economy could fall back into a recession. The risk as well as the conditions in the credit markets and the deterioration in economic data forced the Federal Reserve to cut interest rates for the first time since 2003. However the tables turned in October when August payrolls was revised from -4k to +89k, If the US economy manages to skirt a recession, allowing the Federal Reserve to keep interest rates unchanged at the end of October, gains in the US dollar may cap the rally in the Aussie.

[B]Reserve Bank of Australia vs Federal Reserve: Battle of the Central Bankers[/B]
A by-product of Australia’s and the US’s growth forecasts, the divergence in monetary policy has become another major driver for AUDUSD strength. The Reserve Bank of Australia (RBA) last raised its overnight lending rate in August by 25 basis points to an 11 year high of 6.50 percent. RBA Governor Glenn Stevens made it abundantly clear that he sees no reason to relax monetary policy, even with the recent ripple in the global credit market. The central banker remarked last month that the economy remains “strong.” More than likely, the outlook on expansion has to perform only well enough to allow the policy group to keep its concentration on inflation. Should growth hold steady, the RBA will remain fully occupied by core inflation hovering just below the central bank’s tolerance limit since peaking in 2006. Futures tied to Australian interest rates have priced in at least one more rate hike by the first quarter of 2008.
Australian monetary policy will continued to be measured against the Federal Reserve’s bias. The Australian dollar already enjoys a considerable 175 basis point premium over the US lending rate, but the forecast for future shifts in lending rates is clearly where the AUDUSD’s potential lies. The Fed has already set a somber tone for its own policy stance going forward, not to mention for other major central banks around the globe. On September 18th the Federal Open Market Committee announced its decision to cut the nation’s primary lending rate by 50 basis points to 4.75 percent. Despite the considerable effort to forewarn the market of this impending shift from its previous neutral stance, the impact of the cut was hardly dampened. What’s more, expectations have been officially tipped lower, with further cuts priced into the futures market. However, there may be a glimmer of hope for the greenback. The minutes to the Fed’s two-day meeting in September offered no concrete indication of future cuts in the pipeline, perhaps buying time for the credit market to stabilize and inflation to come back into focus. After the report was digested by the markets, the probability of an October rate cut derived from Federal Funds futures dropped from 48 percent to 36 percent. So far, we have not seen a reaction in the AUD/USD despite a shift in interest rate expectations. This price action is important because it illustrates the overall demand for high yielding currencies.

After the Canadian currency’s momentous rise to parity against the benchmark US dollar, the strength of the commodity bloc and the significant weakness of the staple greenback were brought into focus. Considering the market currents that have consistently driven the loonie to its psychological high against the Forex market’s most liquid currency, it is easy to draw comparisons between USDCAD and AUDUSD. Australia is among the largest exporters of many of the world’s key commodities, while the US is one of the largest consumers of natural resources. What’s more, the basic divergence in growth is clearly tipping towards the momentum underlying the Aussie economy with consumer spending, business investment and export income promising strength for the economy and currency in the months to come. Finally, the ever-present interest in the carry trade certainly favors the already high overnight lending rate attached to the Australian dollar, especially with the RBA holding true to its hawkish convictions and the Fed taking a big first step in a potential new easing trend. As a result, the Australian dollar hitting parity with the US dollar is not only possible, but probable.