Australian Dollar Shrugs Off Mixed Inflation Report as Bond Market Dominates

- Australian headline and core inflation hit 1.9% in first quarter.

- Further progress needed before RBA rate hike is on the cards.

- AUD driven by bond market as anlaysts differ on Buy or Sell question. 

© Filipe Frazao, Adobe Stock

The Australian Dollar saw mixed trading during the morning session in London Tuesday as currency markets responded to the latest price action in the bond market and a quarterly inflation report from down under that failed to draw a decisive bid for the Antipodean unit. 

Much like Tuesday's currency performance, the first-quarter Australian inflation report was also a mixed affair, with headline inflation missing economist expectations while the more refined and important measure of core inflation was in-line with the consensus.

Headline inflation was 0.4% during the three moths to the end of March, which is down from 0.6% in the final quarter of 2017 and below the consensus for a reading of 0.5%. This made for an annual rate of 1.9%, according to the Australian Bureau of Statistics.

Trimmed mean inflation was 0.5% during the recent quarter, which is up from 0.4% in the previous period and in-line with market expectations. This measure removes the 30% of most volatile items - normally food and energy - from the goods basket and so is seen as a more representative of domestically generated inflation pressures. 

"The Q1 inflation data will support the case that monetary policy is set to be on hold for some time to come – we continue to see the cash rate steady at 1.5% until May 2019. Focus now turns to WPI data on 16 May," says Jo Masters, a senior economist at ANZ Research, a division of Australia and New Zealand Banking Group. 

Markets care about inflation numbers because it is changes in price pressures that central banks are attempting to manipulate when they tinker with interest rates and it's these rates themselves that are the predominant driver of currency prices given their influence over relative returns and international capital flows.

The Reserve Bank of Australia (RBA) has an obligation to set monetary policy so as to ensure that inflation remains within the 2% to 3% target band. As things stand, it has left the official cash rate unchanged at a record low of 1.5% for what will be two years this August and markets do not currently anticipate an increase until well into the 2019 year.

"Putting them together, the underlying inflation is around 1.95%y/y, firmer than the expected around 1.85%. That is still well under the “mid of 2-3% inflation target range” that Lowe prefers in order to move the cash target rate," says Saktiandi Supaat, an FX strategist at Maybank in Singapore.

As far as an observer can tell, the in-line core inflation result appeared to have offset to poorer than expected headline number as the overall inflation produced little movement in foreign exhange markets overnight. Instead, currency traders are said to have continued taking their lead from bond markets.

"The AUD dropped overnight, along with other commodity currencies, as yield differentials came back into focus and some positioning unwind continued," says Giulia Lavinia Specchia, an FX strategist at ANZ Research.

Above: AUD/USD rate shown at weekly intervals. Captures break of long term trend.

The Australian Dollar fell against the US Dollar and Canadian Dollar overnight but rose a fraction against Pound Sterling, the Euro, Japanese Yen and New Zealand Dollar. This saw the AUD/USD exchange rate quoted 0.04% lower at 0.7600 while the Pound-to-Aussie rate was 0.04% lower at 1.8221. 

Above: Pound-to-Australian-Dollar rate shown at weekly intervals.

"AUD/USD has eroded major support at .7637/36, the 2016-2018 uptrend. Failure here targets initially the .7501 December 2017 low and ultimately the 2001-2018 uptrend at .7142. We notice the 13 count on the 240 minute chart and will attempt to sell a rally," says Karen Jones, head of technical analysis at Commerzbank.

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Bond Market Dominates AUD and Currencies at Large 

Bond yields have been the dominant driver of currency markets in recent days, with the US Dollar advancing on all of its developed world rivals after drawing some belated support from bond yields that offer increasingly attractive returns relative to their international counterparts.

After all, the Federal Reserve has raised its interest rate six times since the end of 2015 while other other G10 central banks have, at best, only recently begun to contemplate lifting their own interest rates from their post-crisis lows. 

This, and the RBA having sat on its hands for the best part of two years, is what has been behind recent moves that have pushed the Australian Dollar down below the key 0.7637 level of support against the US Dollar on Monday and into Tuesday. 

"This pair was weighed by a number of factors including strong USD and the fall in copper prices. Iron ore also came off yesterday. In addition, the focus at this point is monetary policy divergence as UST 10yr yield flirts with the 3%-level. Market players are penalizing the AUD for RBA’s reluctance to hike in this current theme of monetary policy divergence," says Maybank's Supaat.

Traditionally, investors could earn a higher return by selling US Dollars or a range of other developed world currencies and buying Australian Dollars in order to park their money in the Aussie bond market. 

Now the maths behind this idea no longer works as US bond yields are higher than their Australian counterparts across most durations, which is undermining a crucial source of support for the Aussie currency.

Relative to other currencies, the maths is also becoming less compelling given the RBA is standing still and the likes of the Bank of Canada and Bank of England have both begun to raise their own interest rates.

Buy AUD/USD and AUD/NZD say Strategists

Still, not everybody is downbeat in their outlook for the Australian Dollar as some say the RBA will raise rates sooner than the market gives it credit for. 

"We remain of the view that AUDUSD pullback could be the last chance for us to buy the antipode as AUD typically rises in a growth environment with modest inflation. This is backed by its correlation with base metals and gold," says Maybank's Supaat. "We stick to our view that dips towards 0.76-figure are seen as opportunities to buy."

Supaat and the Maybank foreign exchange team have grown bullish on the AUD/USD exchange rate throughout April, correctly calling last week's run at the 0.7813 level, and are still flagging potential upside during the months ahead. Their forecast is for the exchange rate to reach 0.83 before 2018 draws to a close. They are not alone either. 

"The cross has bounced nicely off the uptrend support from the cycle low in April 2015, and we are looking for further upside with the RBNZ firmly on hold and the market underpricing the chances of an RBA hike this year," says Alvin Tan, a foreign exchange strategist at Societe Generale, referring to the AUD/NZD exchange rate. 

Tan recommended a week ago that clients buy the AUD/NZD rate around 1.0550 and target a move up to 1.10, placing a stop loss at 1.0490. The ANZ Research team has also recommended betting on a rise on the AUD/NZD rate, targetting a move up to 1.08.

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