The Parity Trade You Forgot About: AUD/NZD
- By Ben Ford
- 3 min read
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Summary
- AUD/NZD traded in cycles since the early 1980s. However, something changed from 2014. The currency pair went broadly sideways for eight years.
- The rangebound trading can be attributed to narrow spreads and poor commodity performance. However, things are changing.
- Two-year rate spreads will weigh on AUD/NZD. We believe the RBA and RBNZ policy rates will diverge by at least a percentage point.
- Australia’s commodity advantage has likely worn itself out. China’s Party Congress failed to boost the outlook for steel demand. Meanwhile, China has continued to increase its imports of food and resources alike.
- A US Dollar peak could see AUD/NZD lower. Indeed, AUD/NZD tends to fall 10.9% in the following six months, and 13.3% over the following year.
Market Implications
- We turn short on AUD/NZD – it could reach parity.
AUD/NZD Is Heading to Parity
AUD/NZD has appreciated sharply over the past year, reaching 1.14 in late September. It is a trade that has earned over 10% in one year with a 2.2 Sharpe ratio! Recently, AUD/NZD has tumbled 2.8%, which we think could be the start of a larger move to parity. Here are three reasons why:
1) Rates Divergence to See AUD/NZD Trend Again
AUD/NZD traded in cycles since the early 1980s. Typically, downtrends lasted three-and-a-half years and uptrends lasted four-and-a-half years, on average (Chart 1). However, something changed from 2014. The currency pair went broadly sideways for eight years.
The clearest culprit for the AUD/NZD range was likely the convergence of RBA and RBNZ policy rates (Charts 2 and 3). We think that era is over. We believe the RBA and RBNZ policy rates will diverge by at least a percentage point. So, with the two-year rate spreads mattering again, they will likely weigh on AUD/NZD and see it fall further (Chart 4).
2) AUD Losing Commodity Support
In 2020, coal and iron ore prices skyrocketed. It helped Australia build an impressive trade surplus and a major advantage over New Zealand (Charts 5 and 6). However, it has likely worn itself out. Indeed, China’s Party Congress revealed no boost to dwindling steel demand while the zero-Covid policy was reiterated. Meanwhile, China has continued to increase its imports of food and resources alike – more than 50% of New Zealand’s exports to China. As a result, continued China economic stagnation could drag AUD/NZD lower.
3) Peak Dollar Could See Lower AUD/NZD
AUD/NZD tends to fall following a USD peak (Appendix: Tables 1 and 2). The US dollar has been the answer to everything this year! We think this will eventually change; the US dollar will peak soon. Looking at the past two tops (proxied by DXY), we find AUD/NZD tends to fall 10.9% (’85: -16.8%; ’02: -5.0%) in the following six months, and 13.3% over the following year (’85: -14.7%; ’02: -12.0%).
Bottom Line
Overall, we think AUD/NZD has enough bearish factors to suggest a move down to parity , which could occur over the coming months, so we enter a short AUD/NZD trade. As for risks, we would flag three. First, AUD/NZD has tended to rally on with equity underperformance, though the correlation has weakened of late (Chart 7). Second, US recessions tend to see AUD/NZD strengthen (Appendix: Table 2). Third, the RBA do not hike aggressively enough and must hike for longer while the RBNZ overtighten and eventually must ease. This would put the rate spread back in favour of AUD. For now, we think relative rates and the commodity story will be enough to dominate the currency cross.
Appendix