The Australian Dollar Underperforms as Market Weighs RBA's Next Steps 

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- AUD hits bottom of G10 even after Trump-Xi detente at G20 in Japan.

- Investors eschew AUD ahead of key interest rate decision on Tuesday.

- Markets betting heavily on 2nd cut, but some say RBA can be patient.

- But regardless of Tuesday's decision, AUD set to struggle in short-term.

The Australian Dollar fell to the bottom of the G10 league table Monday as investors weighed the likely next move of the Reserve Bank of Australia (RBA) which is set to announce its latest interest rate decision in the early hours Tuesday, with implications for the Antipodean currency. 

Australia's Dollar ceded ground to all of its G10 rivals during the Monday session even after Presidents Donald Trump and Xi Jingping agreed a ceasefire in the trade war between the world's two largest economies, which should have positive for the China-sensitive Aussie. 

However, markets eschewed the Antipodean currency ahead of the 05:30 am Tuesday interest rate decision due from the Reserve Bank of Australia, which will have significant implications for the currency's short-term outlook. 

Above: Australian Dollar performance Monday Vs G10 rivals.

"The AUD's reaction this morning shows how much the market is betting on a rate cut by the Reserve Bank of Australia (RBA) tomorrow morning," says Antje Praefcke, an analyst at Commerzbank. "The market expects a rate cut tomorrow, and we also see a good chance that the RBA will take action again. But it could also afford to wait a little longer. Either way, the AUD will have a hard time in the short term."

Consensus is for the RBA to cut its benchmark interest rate from 1.25% to a new record low Tuesday, which would mark the second cut in just as many months, in order to provide the economy the stimulus that's now seen as necessary for the bank to meet its inflation target. 

Australian inflation has been below the 2%-to-3% target for much of the time since the end of 2014 and after more than four years of patiently waiting for price pressures to pick up, the Aussie central bank lost patience in June. 

The decision to cut rates came amid an escalating U.S.-China trade war and hard on the heels of official data that showed the economy expanding in the first-quarter of 2019 at a slower pace than what the RBA deems necessary for inflation pressures to lift. 

Australian annualised GDP growth was just 1.8% in the first quarter, below the RBA's estimate of 'trend', while the economy grew just 2.3% in 2018 as a whole. The 2018 number was down from 2.8% in 2017 and a long way off the lofty 3% or more previously forecast by the central bank. 

"A surprise would be if the RBA decided, contrary to market expectations, to keep rates on hold tomorrow and wait for further developments in the labour market. In this case, the AUD would see a jump to the upside. But this would hardly be sustainable either, since in view of the global trend it can be expected that the next rate cut will come sooner or later," says Praefcke, in a note to clients. Regardless of how the RBA decides tomorrow, the AUD will continue to have a hard time in the short term."

Above: Commerzbank graph showing Australian inflation Vs RBA inflation target band.

"Bond yields have declined aggressively in recent months as the market anticipates a low inflationary backdrop for the economy. An interest rate cut this week would take to cash rate to a low of 1.0% and further interest rate cuts this cycle are a strong possibility," says Jane Foley, a strategist at Rabobank. "There are plenty of risks facing the economy that suggest that further policy action by the RBA this year would be justified. We see risk of AUD/USD edging towards 0.67 by the end of the year."

Changes in interest rates are normally only made in response to movements in inflation but impact currencies because of the push and pull influence they have over capital flows, and their allure for short-term speculators.

Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. Rising rates have the opposite effect.

Praefcke says there are two-way risks around Tuesday's RBA decision because it could decide not to cut this month. But the Commerzbank team still see more rate cuts coming this year and the bank is not alone either. But not all are bearish in their outlook for the Aussie currency. 

"We expect the RBA to cut the cash rate and deliver a ‘neutral’ message in their post‑meeting statement tomorrow.  In response, we expect AUD/USD will increase modestly by 0.2‑0.3%," says Joseph Capurso at Commonwealth Bank of Australia. "There may be further a reaction by AUD/USD following the announcement by Australian commercial banks about changes to their mortgage interest rates in response to a RBA cut."

Above: AUD/USD rate shown at daily intervals, alongside the Dollar Index (aqua line, left axis).

"The commercial banks typically make an announcement within a few hours of the RBA’s decision.  The smaller the interest rate cuts announced by the commercial banks, the more ‘need’ markets may perceive for follow‑up cash rate cuts by the RBA.  Under this scenario, the interest rate market may price more cuts by the RBA, guiding AUD/USD lower," Capurso explains. 

For his part RBA Governor Philip Lowe has said the jobs market is key to the outlook for consumer spending, the economy and its inflation target. And the unemployment rate has now risen from 4.9% in February to 5.2% in May, which is why the market expects further rate cuts.

But Capurso and the Commonwealth team say the Australian Dollar has already paid for the RBA cuts that markets are betting on and for this reason, they're sceptical of whether future rate cuts will really be able to do any more damage to the currency.

This is especially the case now the U.S. Federal Reserve and other central banks are also expected to cut their interest rates over the coming months too. 

CBA forecasts the AUD/USD rate will rise on Tuesday following any RBA cut and that it will reach 0.72 by year-end. The Pound-to-Australian-Dollar rate is expected to fall from 1.8106 Monday to 1.7777 by year-end. 

"Finally, AUD/USD may also react to remarks by RBA Governor Lowe at a dinner with the business community tomorrow night (7.30pm Sydney time, 10.30am London time, 5.30am New York time).  His remarks provide an opportunity to reinforce the policy decision," Capurso adds.

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

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