RBA Decision Could Lead to Australian Dollar Weakness

How Will The Markets React?

The Reserve Bank of Australia is expected to leave the overnight lending rate unchanged at 6.25 percent at its forthcoming policy meeting, but sufficient speculation surrounds both a possible hike and cut that it warrants event risk for the markets. What’s more after the surprise hikes in August and November of last year, a surprise shift under the leadership of Governor Glenn Stevens does not seem out of the question. As of now, speculation is falling more in favor of a trimming of rates rather than a firming, but recent data seems to support the latter, or at least a pass with a caution on the necessity of future hikes. In the past few weeks, indicators have shown strength in both growth and inflation figures. For economic activity, the recently release 2.2 percent pace in third quarter GDP has colored a negative bias in the market, but both the key housing and consumer sectors have offered positive turns. Furthermore, inflation gauges are still running outside the central bank’s tolerance band. Recently, the government reported annual inflation growth of 3.3 percent in the fourth quarter, still above the 3 percent cap the RBA has self-imposed. It remains to be seen though whether these more up-to-date readings will be enough to trigger the hawkish sentiment amongst policy makers who have seen a broader slow down in economic activity and price pressure. Should a dovish turn emerge, it would certainly shake the financial markets, as they have not seen such a turn from the policy group in some time. This would be an interest development given the support in AUDUSD, and conversely the resistance forming in bonds and equities.

Bonds – Australian 10-Year Bond Yields

Australian 10-Year Bond Yields clearly reflect recent shifts in expectations for domestic interest rates, with the government bond completely unwilling to rise above 5.95 percent through the past 6 months of trade. The chart below shows that yields have effectively formed a quintuple top at the psychologically significant mark, and a recent drop on poor retail sales figures has been enough to leave them near 2-month lows. Today’s price action compares to the drop following fourth quarter inflation numbers, as traders significantly scale back predictions of any medium-term rate hikes. Risks subsequently remain to the downside for the rate-sensitive Australian dollar, with recent strength in commodity prices saving the currency from more pronounced declines.

FX – AUD/USD

The RBA’s rate decision may be the trigger currency traders have been waiting for for the past weeks. While the ultimate decision may not result in a hike or cut, the actual vote could settle heated speculation that has underpinned the Australian dollar. Recently, data has put the possibility for another firming in overnight lending back on the table. With the knowledge that Governor Glenn Stevens has erred on the hawkish side in his voting record, the stubborn subsistence of inflation above the 3.0 percent limit and a hearty rebound in both the housing and consumer sectors has encouraged Aussie dollar bulls to wait out the decision. However, the previous rate decisions have come at a time when price pressures and economic growth showed not only pressure in past data, but also offered the impetus for future strain. Conditions this time around are not as consistent. While both the housing and consumer sectors have shown promise, their overall trend is towards further weakness. What’s more, the economy is still burdened by its worst drought in a century which could lead to underperforming growth for months to come.

While the economics and behavioral statistics of the RBA are open to debate, the technical formation in AUDUSD is a little more clear cut. Two weeks ago, after two days of strong Aussie selling, the pair broke the neckline of a heads-and-shoulder formation that was two months in the making. Since then, however, AUDUSD has floundered – refusing to extending the slide. Should a surprise hike be found, a rebound to the 0.79 shoulder would be easily achievable. On the other hand, if a cut or ultimate pass is in the cards, bulls may give up on their positions and the unwinding could finally open AUDUSD to an extended drop (barring any cross currency fundamentals).

Equities – S&P Australian Stock Exchange 200 Index

Australian equity markets have clearly benefited from decreased interest rate hike speculation, with the S&P/ASX 200 Index continuing set all-time highs through recent trade. Stable interest rates will only help corporate profitability, providing a much-needed boost to falling capital investment. Previously soaring commodity prices boosted liquidity in the domestic economy, allowing businesses to quickly step up investments and boost broader economic growth. Given that world raw material prices have since stabilized, however, Australian industry has seen considerably lower investment rates. Businesses subsequently hope that interest rates have peaked through 2007, with any perceived RBA hawkishness to potentially damage Australian equities strength.