Australian Markets Readying for Key Consumer Price Index Data

How Will The Markets React?

Inflation and interest rates are at the front of nearly even Australian investor, whether they are putting one foot in by trading the Australian dollar or diving in with positions in the nation’s equity or bonds market. Since early last year, financial markets have closely followed the Reserve Bank of Australia in order to divine a head start on rate hikes. The most recent shift in interest rates came in November when the policy body decided to lift the overnight cash rate 25 basis points to 6.25 percent in order to choke off inflation that was stoked by energy and food prices, as well as a consumer demand. Since then, however, the outlook has undergone a few changes. Import and producer price indices have provided lackluster evidence for inflation hawks. Already expected to be hit hard by the sharp drop in global energy prices, the gauge measuring imported inflation fell more than expected in the fourth quarter. The 3.2 percent plunge reported for the final months of the year was the biggest contraction since the first quarter of 2004. More influential for policy makers, the producer price gauge for the same period was also on the lam. Now, the pressure is building behind one indicator, the Consumer Price Index. The official consensus sees 0.2 percent growth for the quarter – what would be the slowest pace of inflation in three years. Alone, this could encourage the central bank to stand pat as it may expect further cooling as cheaper energy and food prices factor in. Conversely, a predicted 3.6 percent print for the annual gauge would mark the third quarter in which the key inflation read has printed outside of policy makers’ 2-3 percent comfort band.

Bonds – Australian 10-Year Treasury Bonds

Australian bond yields reflect the uncertainty in the market surrounding fourth quarter inflation numbers. After marking an impressive run through the most of December, the yield on the 10-year Treasury note has been neutralized just below 5.95. This apprehension is well founded as speculation calling for tepid fourth quarter inflation rates builds. However, since the third quarter inflation numbers hit the wires, speculation has soured for future rate hikes. Even though consumer inflation was well above the RBA’s tolerance level, the market was already adjusting for the sharp drop in energy prices which was expected to take full effect in fourth quarter data. This concern was likely the reasoning behind the short-lived response to the RBA’s hike in November.  Now with yields positioned on major resistance, the consumer inflation numbers could define the next trend in bonds.

FX – AUDUSD

The Australian dollar has continued to strengthen through the past two weeks of trade, as carry-trade interest has provided strong bids for the high-yielding currency. Whether or not interest rate-linked demand will continue to drive the currency will largely depend on upcoming economic data, however, leaving downside risks for AUD-denominated currency pairs. Tomorrow’s Consumer Price Index data will likely prove critical to the future of domestic interest rates, as fourth quarter inflation numbers will almost definitely influence the Reserve Bank of Australia’s decision of whether or not to raise interest rates at its February meeting. Currency movements suggest that traders remain little concerned about the prospects for falling inflation. This was easily visible through today’s trade, with the AUDUSD shrugging off weak Producer Price Index figures to actually close higher through the New York session.

The overall implications for currency markets are mixed. On the one hand, it is relatively clear that Australian inflation moderated through the final quarter of the year. With TD Securities’ proprietary monthly inflation metric showing much more modest price pressures, the official figure will almost definitely follow suit. On the other hand, the extent of the ease in inflation is still very much up for debate. Consensus estimates show expectations of a 3.6 percent year-over-year rate; if this proves true, headline price pressures will still remain far above the RBA’s target of 2-3 percent. Such an outcome would almost certainly boost the likelihood for further interest rate hikes through the medium term—thereby improving the attractiveness of AUD-denominated carry trades. If inflation figures disappoint, however, we could easily see the inverse happen; the Australian dollar could sell off in anticipation of stable interest rates through the medium term. 

Equities – S&P/ASX 200 Index

Australian stocks have shown relative disregard for the impending inflation figures, with the S&P/ASX 200 Index setting all-time highs through recent trade. Overall price action may be slightly misleading, however, with a very recent rally in commodity prices providing the spark needed to drive domestic shares higher. If we look to the reaction that followed yesterday’s Producer Price Index figures, the S&P ASX 200 actually fell in the moments following the release of the report. Markets were clearly less than pleased to see Producer prices gain at a 3.5 percent year-over-year pace through the final quarter of the year. Resilience in the index’s biggest issues was primarily due to commodity prices, but it cannot be denied that investor—to a certain extent—shrugged off fears of a similarly elevated Consumer Price Index read. If equity price action proves an accurate gauge of investor sentiment ahead of tomorrow’s key report, we see that risks remain to the downside for the Australian stock market if numbers come in line with expectations. If, on the other hand, stock market predictions prove to be accurate, a soft inflation figure could provide downward pressure on domestic interest rates—leaving the Australian dollar lower in its wake.