As the Euro nears parity with the Dollar, it has sparked conversations about what this could mean for the global economy and FX traders. Discover how the economic theory of parity influences FX trading strategies.
What is currency parity?
Currency parity occurs when the exchange rate of two currencies reaches equality, so that only one unit of one can be exchanged for only one unit of the other. For instance, €1 could buy $1.
What is Purchasing Power Parity (PPP) Theory?
Purchasing power parity is an economic theory that compares the economic productivity and standard of living of two countries using a basket of goods and services. The idea is to establish which currencies are overvalued and undervalued, as they will eventually reach parity over time.
The PPP theory is used by some forex traders to assess the movement of the foreign exchange markets. They would sell overvalued currencies and buy undervalued currencies, hoping that the exchange rate will balance out over time.
In the case of EUR/USD, this has resulted in many short EUR positions being opened as the Eurozone economy weakens.
Critics of purchasing power parity
Using purchasing power parity gives mixed results in the short term, as it sometimes takes a long time for currencies to reach parity. Currencies can stay overvalued or undervalued for years, so for day traders this should only be part of their strategy.
Will the dollar and the euro reach parity?
The dollar and euro are on the verge of reaching currency parity for the first time since 2002. The euro has been depreciating against the US dollar for over a year, but hit $1.03 in early July , triggering discussions on whether parity will be achieved.
The euro’s decline was spurred by the divergence in monetary policies between the two economies, resulting in a wider interest rate differential.
While the Fed’s previously low interest rates had helped keep the euro above the dollar, the Fed has now started raising interest rates to contain inflation. But the European Central Bank has yet to raise rates despite record inflation gripping the eurozone – largely on fears that rate hikes could spark another debt crisis.
This lifted the dollar against the euro – as well as other global currencies.
What happens if the EUR/USD parity is reached?
If the EUR/USD parity is reached, it is unlikely that much will change in the short term for the European Central Bank. Analysts still expect the ECB to leave rates unchanged or raise interest rates less aggressively than the Fed. If the ECB were to raise rates, it would mark its first hike since 2011.
But the Federal Reserve could act and slow its monetary tightening. Many have already noticed that the dollar index is too high – up 8% year-to-date thanks to safe-haven inflows.
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