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Australian Dollar Hammered after Core-inflation Fall Seals Deal on RBA Interest Rate Cuts 

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- AUD hurt after inflation disappointments seal deal on RBA cuts for 2019.

- Core inflation falls, price declines hit RBA's housing-sensitive products.

- Market bets on rate cuts as economists look for action as soon as May.

- GBP/AUD to challenge 2019 high again before end-June says Westpac.

The Australian Dollar was hammered on Wednesday as traders dumped the Antipodean currency after official data revealed surprise falls in both key measures of inflation during the first-quarter, raising pressure on the Reserve Bank of Australia (RBA) to cut its interest rate. 

Australian inflation was unchanged at 0% in the opening quarter of the year, down from 0.5% in late 2018, when markets had been looking for an increase of 0.2%. That pushed the annualised rate of inflation lower to just 1.3% for the recent quarter, down from 1.8% previously. 

Core inflation rose by just 0.3% in the quarter, down from 0.4% previously, when markets had looked for an unchanged 0.4% reading. That knocked the annual pace of trimmed mean inflation down to 1.6%, from 1.7% previously. 

"We have been looking for two rate cuts this year since last December and had thought that the RBA would wait till after the election before starting to move. However, with underlying inflation coming in much weaker than expected our base case is now that the first cut will come next month, with the RBA likely to conclude that it’s too risky to wait until unemployment starts to trend up," says Diana Mousina, an economist at AMP Capital

The RBA cash rate for December 2019 implied by pricing in the overnight-index-swap market fell to just 1% on Wednesday, down from 1.13% on Tuesday and far beneath the actual cash rate of 1.5%. This is investors fully pricing in two interest rate cuts from the RBA before the year is out.

Above: Australian Dollar performance against G10 rivals on Wednesday. Source: Pound Sterling Live.

Australian policymakers have long battled against weak price pressures that have left inflation beneath the lower bound of the 2%-to-3% target and to that end, the cash rate has been at a record low of 1.5% since mid-2016. 

However, the RBA said repeatedly in recent months that it could cut rates if inflation falls further below target and if unemployment sees a sustained pick-up. The unemployment rate rose to 5.% in March, from 4.9% previously. 

"The downward surprise to core inflation in Q1 leaves the RBA will little choice but to cut the cash rate by 25bp at its May meeting, with another 25bp likely to follow in August. The much lower than expected outcome for core inflation means that something has to materially change in order for the RBA to credibly forecast an eventual return to 2%," says David Plank, an economist at ANZ

Above: Australian inflation rates and product contributions. Source: Australian Bureau of Statistics.

Notably for the RBA, Australian Bureau of Statistics figures revealed Wednesday that the largest price increases during the recent quarter were among alcoholic beverage and tobacco products. Those prices often rise because of regulatory measures rather than as a direct function of demand. 

However, price falls were recorded across the clothing and footwear as well as furnishings, household equipment and services categories. Those have previously been identified by the RBA as sectors that are likely to suffer if home price declines hurt household confidence. 

The fact that prices are already falling in exactly those sectors could suggest demand is weakening and that slower consumer spending growth more generally might be in the cards for the coming quarters. 

House prices fell in all of Australia's latest cities last year following years of runaway increases, prompting fears of negative wealth effects that dent confidence among and eventually hurt the economy by deterring spending.

Regulatory measures aimed at curbing irresponsible lending by banks combined with an organic loss of demand were seen behind the declines, although higher international funding costs have also pushed up mortgage rates charged by all of Australia's major banks. 

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

The Pound-to-Australian-Dollar rate was 0.72% higher at 1.8362 during the morning session Wednesday and is now up 1.44% for 2019. 

"Our base case of GBP/USD roughly range-bound in the low 1.30s and AUD/USD slipping back to around 0.70 implies AUD/GBP returns to the 0.5325/50 area, GBP/AUD to 1.8700/50 by end-June," says Sean Callow, another strategist at Westpac, in a recent note to clients.

Currency markets care about inflation data because of what it could mean for the interest rate policy of the relevant central bank as rate decisions are normally only made in relation to the inflation outlook but impact currencies because of the influence they have over capital flows and the opportunity they provide short-term speculators. 

Australian rate setters need either faster wage growth for households, which requires more jobs and lower unemployment, or they need faster economic growth in order to get the consumer price index back into the target band.

 

Above: AUD/USD rate shown at daily intervals.

"The RBA has been focused on Australia's strong labour market but markets are betting that it won't be able to brush off the weak Q1 inflation data. The debate over the timing of an RBA rate cut should dominate AUD/USD near term, overshadowing a more positive global mood," says Frances Cheung, a strategist at Westpac

The AUD/USD rate was quoted -0.80% lower at 0.7039 during the morning session Wednesday and is now down -0.17% for 2019 after trading on an annual gain for much of the New Year. 

"AUD/USD has been rejected by .7207, the end of February high and the emphatic rejection has seen the market erode the 2019 uptrend. Failure here has provoked a sell off and we would allow for further near term weakness to the . the .7004 March low and the .6950 61.8% retracement. Below .6950 there is scope for the .6857/78.6% retracement," says Karen Jones, head of technical analysis at Commerzbank

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