Australian_Dollar_Weakness_Ahead_On_Slowing_Inflation_body_Picture_5.png, Australian Dollar Weakness Ahead On Slowing InflationAustralian_Dollar_Weakness_Ahead_On_Slowing_Inflation_body_Picture_6.png, Australian Dollar Weakness Ahead On Slowing Inflation

Fundamental Forecast for Australian Dollar: Bearish

The Australian dollar advanced to a fresh monthly high of 1.0480 following the rise in risk-taking behavior, but the high-yielding currency may come under pressure next week as the fundamental outlook for the region deteriorates. Indeed, the 4Q Consumer Price report highlights the biggest event risk for the Aussie, and the development may trigger a selloff in the AUD/USD as the headline reading for inflation is expected to expand at a slower pace during the last three-months of 2011.

In turn, the Reserve Bank of Australia is widely expected to further reduce borrowing costs this year, and we will maintain a bearish outlook for the high-yielding currency as interest rate expectations remain weak. According to Credit Suisse overnight index swaps, market participants see the RBA lowering the cash rate by another 100bp over the next 12-months, and the weakening outlook for growth and inflation is likely to heighten speculation for additional monetary support as the central bank tries to balance the risks surrounding the economy. At the same time, the slowing recovery in China – Australia’s largest trading partner – fosters a bearish outlook for the AUD/USD as the world’s second largest economy faces an increased risk for a ‘hard-landing,’ and we may see the RBA aggressively scale back the slew of rate hikes from 2009 as the region faces a protracted recovery.

As the rally in the AUD/USD tapers off ahead of 1.0500, the weakening outlook for growth and inflation is expected to drag on the exchange rate, and we expect to see a short-term reversal next week as long as the relative strength index holds below 70. However, as risk sentiment continue to dictate price action in the foreign exchange market, currency traders may turn a blind eye to the developments coming out of the $1T economy, and the high-yielding currency may continue to outperform against its major counterparts as it benefits from the rebound in risk-taking behavior. – DS