Reserve Bank Warning of Inflation Disappointment Dents the Aussie but Some Analysts say to Buy AUD/USD

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The Australian Dollar pivoted onto its back foot Tuesday as traders responded to a dovish interest rate statement from the Reserve Bank of Australia (RBA) that may have forced the market to abandon any remaining hope of a change in monetary policy coming at some time in 2019. 

Reserve Bank of Australia governor Philip Lowe said the outlook for both domestic as well as global economies is bright but that Aussie inflation pressures are still too weak for the bank to contemplate an interest rate rise. On this note, Lowe warned that inflation could disappoint both RBA officials and the market later this year. 

"Inflation is around 2 per cent. The central forecast is for inflation to be higher in 2019 and 2020 than it is currently. In the interim, once-off declines in some administered prices in the September quarter are expected to result in inflation in 2018 being a little lower than otherwise," the governor says, in a statement. 

It goes almost without saying the RBA held its interest rate at a record low of 1.5% for what is now the 27th consecutive month, citing below-target inflation and a range of factors likely to delay the return of the consumer price index to levels that are closer toward the upper end of the 2% to 3% target band. 

Changes in interest rates, or hints of them being in the cards, are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

"Market analysts are largely weighing up how the competing forces of a tightening labour market against a deflating housing market are likely to impact the future path of the cash rate. As such, the governors comments on both issues were of most interest to us today," says Gareth Aird, a senior economist at Commonwealth Bank of Australia. 

Lowe sounded an optimistic tone on the outlook for Australia's labour market, saying the economy is expected to continue creating jobs at a decent clip and that this will eventually yield a further pickup in wage growth, which should support the inflation outlook. 

However, Lowe also warned that conditions in the Sydney and Melbourne housing markets have changed for the worse, while noting that credit conditions are tightening now funding pressures have prompted domestic lenders to begin raising their interest rates. 

"We have pencilled in Q4 2019 for a rate hike, but a lot can happen before then, of course. Trends in the housing market are likely to be key. Any further acceleration in dwelling price deflation or further slowdown in credit growth, due to higher mortgage rates or a tightening in lending criteria, would raise the hurdle for policy tightening," says Aird. 

Pricing in interest rate derivatives markets, which enable investors to protect themselves against changes in borrowing costs while providing insight into expectations for monetary policy, implies a November 2019 RBA cash rate of 1.64%. This suggests markets see only around a 50% probability of a rate hike by then. 

 "The AUD OIS curve drifted a few basis points lower as investors scaled back expectations of a 2019 RBA rate hike; this, coupled with a broadly bid USD, has seen AUD/USD move below the 0.72 level. We see 0.72 as a short-term anchor point for the pair – with equal risks of a move either side," ," says Viraj Patel, an FX strategist at ING Group.

Above: AUD/USD rate shown at daily intervals.

The Australian Dollar was quoted 0.56% lower at 0.7187 against the U.S. Dollar Tuesday while the Pound-to-Australian-Dollar rate was 0.14% higher at 1.8071, denoting a weaker Aussie relative to both currencies. Australia's Dollar was lower against all of its G10 rivals Tuesday morning. 

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

"There are indications that the USD is beginning to look tried and tested in recent months, and even more so in recent weeks (as our CTA positioning indicator suggests). We like the risk/reward of buying towards 72c in AUDUSD for a squeeze towards 0.7350/0.74," says Mazen Issa, an FX strategist at TD Securities.  

Australia's Dollar has fallen 7.5% against the U.S. greenback and 4.7% against Pound Sterling this year due to a combination of factors including a deteriorating domestic interest rate outlook and the White House trade war against China, which has stoked fears of a global economic slowdown and turned sentiment further against the Antipodean.

President Trump has imposed tariffs on more than $250 billion of China's annual exports to the U.S. in response to "unfair trading practices" that include the alleged forced transfer of technology and intellectual property theft.

He has also threatened to impose levies on all of China's $500 billion odd of annual exports to America if the country's leadership does not change course with its trade policies. 

This has been a problem for the Aussie because it is underwritten by Australia's commodity trade with the world's second largest economy and often serves as a surrogate for speculators seeking to express bearish views about China's state-managed Renmimbi.

The USD/CNY rate has risen 5.6% so far in 2018, denoting a stronger Dollar and weaker Renmimbi. However, strategists at Morgan Stanley say they are looking for the Renmimbi to recover some of its losses over coming weeks and months, which might have positive implications for the AUD/USD rate. 

"China’s domestic demand seems to have strengthened,according to the non-manufacturing PMI index rising from 54.2 to 54.9 in September," says Hans Redeker, head of FX strategy, in a note to clients Monday. "There is a bearish USD dynamic building in the background, it seems. The RMB may soon rebound from the lower boundary of its trading band against the basket."

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