Aussie inflation - first big event of the trading week

Tomorrow’s inflation report could be crucial for Australian markets, especially the Aussie Dollar; the Australia 200 Index and yield related stocks. The latest RBA minutes have seen markets adjusting for the likelihood of an August rate cut. That creates potential for volatility tomorrow.

Inflation and the Aussie markets

Tomorrow’s inflation report could be crucial for Australian markets, especially the Aussie Dollar; the Australia 200 Index and yield related stocks.

Markets are going into this figure expecting both the headline CPI and underlying measures to read about 0.4% for the June quarter. That would put the CPI at +1.1% for the year. The trimmed mean (underlying) measure would be 1.4% for the year.

Based on these assumptions, the market is currently pricing a 66% probability that the RBA will cut its cash rate to 1.5% at its August meeting.

Background

The March quarter inflation data shocked the market.  The CPI read was a surprisingly low -0.2%. This left the annual rate at 1.3%. The underlying, trimmed and weighted mean CPI measures were 1.4% and 1.7% respectively. This puts them well below the RBA’s 2-3% target.

This surprisingly low inflation data led to the RBA cutting rates at its May meeting. It noted that this decision “followed information showing inflation pressures are lower than expected”.

The minutes of the last RBA meeting noted that “further information on inflationary pressures; the labour market and housing activity would be available in the following month….. This information would allow the Board to refine its assessment of the outlook for growth and inflation and to make any adjustment to the stance of policy that may be appropriate”.

It’s clear that inflation data is likely to be the key variable in the Board decision.

Why is inflation getting lower?

There are a range of factors at play. Here are some:

  • Australia’s income has underperformed GDP growth. Real GDP measures the volume of our output as a nation. However, in recent years the price of what we receive for our exports has dropped by more than the price of what we import. This drop in the terms of trade filters through the whole economy and needs to be reflected by either lower incomes or a lower currency or a combination of both.
  • The low wage pressure resulting from the drop in the terms of trade is restraining spending power. The new jobs created tend to be lower paid than the old ones and wage growth for existing workers is restrained.
  •  There is a lot of excess capacity in labour markets and other industry around the world. This is keeping price growth low
  • Competition e.g. between supermarkets and telcos is keeping a lid on price increases
  • Rents have been flat over the year as the supply of new apartments increases

These factors mean inflation could stay relatively low and below the RBA’s target for some time. However, there are some improvements in the pipeline:

  • Commodity prices were generally higher in the 2nd quarter
  • The US economy continues to improve. It’s getting to the stage where prices in the service sector are picking up at the greatest rate since the GFC

Tomorrow’s figure and the markets

Markets appear to have been adjusting for the likelihood of an August rate cut since release of the last RBA minutes. That creates potential for volatility.

 Perhaps the greatest scope for surprise would be if the CPI data is unexpectedly strong. A read of 0.5, or certainly 0.6% in the underlying measures of inflation could have markets back tracking on the outlook for an August rate cut. That would be bullish for the Aussie Dollar and bearish for Australia 200.

The opposite is also very possible. A read of 0.3 or below in the underlying measures would see the market firm up an expectation of 2 more rate cuts to 1.25% this year. That could be quite bearish for Aussie Dollar and bullish for Australia 200

AUDUSD chart

The latest down swing in the Aussie finished neatly at the 61.8% retracement level on Friday. At this stage today’s candle high is neatly at the 38.2% Fibonacci retracement

If we do get CPI volatility, possible supports could be:

  • The 78.6% Fibonacci retracement around .7385
  • The last major low and 200 day moving average around .7305/.7330

If the result is bullish possible resistance could be:

  • 61.8% retracement at .7988
  • 78.6% retracement at .7630
  • Previous high at .7676.