- AUD falls broadly after seventh consecutive inflation disappointment.

- CPI rises to 2.1% as core holds steady at 1.9% in second quarter.

- Analyst views are mixed, as some say hold AUD, others say sell.

© Greg Brave, Adobe Stock

The Australian Dollar fell broadly in the midweek session as traders responded to a weaker-than-expected set of second-quarter inflation numbers, which served only to confirm interest rates at the country's central bank are unlikely to rise anytime soon.

Australian inflation rose by 0.4% during the three months to the end of June, unchanged from the quarter-on-quarter rate of inflation seen back at the start of the year, when markets had been looking for it to rise by 0.5%. This pushed the annual consumer price index up to 2.1%, although economists had looked for a reading of 2.2%.

Trimmed mean inflation, which removes the most volatile 30% of items from the goods basket at each calculation and so is seen as providing a more accurate representation of underlying trends in price pressures, rose in line with expectations at a pace of 0.5%.

This left the annual rate of trimmed mean inflation at 1.9%, also in line with expectations. The trimmed mean inflation number is the preferred indicator used by the Reserve Bank of Australia which is trying to get inflation back above 2%.

"For the seventh quarter in a row inflation has underperformed market expectations," says Justin Smirk, an economist at Australia's fourth largest lender, Westpac. "Without a doubt the Australian economy remains locked in a low inflation environment. Sectors that are experiencing some inflation –particularly tobacco and auto fuel then to a lesser extent, housing, health and education – are mostly being offset by the disinflationary pressure of the competitive squeeze in consumer goods."

Above: Westpac graph showing second quarter inflation dating back to 2004.

Markets care about inflation because it has implications for interest rates, which are themselves the predominant driver of exchange rates because of the influence that rising and falling returns can have on international capital and speculative money. It is inflation that central banks are attempting to manipulate when they tinker with interest rates.

"As has been the case for some time now, the details of the latest CPI release continue to highlight price pressures in a number of key areas which are largely non-discretionary (health, education, transport, housing). These pressures continue to squeeze disposable income amid ongoing modest wages growth. The data are consistent with no change to the RBA’s inflation forecasts," says Adam Cole, chief currency strategist at RBC Capital Markets.

HSBC thinks Australia's central bank right now is more interested on wage data instead of today's CPI reading. While annual inflation of 2.1% is back within the RBA's target band, getting there was largely the result of higher gasoline prices.

In contrast, upward momentum in underlying measures was weak.

"It seems likely that the word of the moment for the RBA is going to continue to be 'gradual' for some time yet," HSBC notes, adding they believe the RBA will need to see enough of a pickup in wage growth before forecasting that inflation will head back to 2.5%. "We think this will take a number of quarters yet."

Where Next for the Australian Dollar?

The AUD/USD rate was quoted 0.29% lower at 0.7404 during early trading Wednesday while the Pound-to-Aussie rate was down 0.40% at 1.7779. It was also down against all other developed world currencies.

Australia's Dollar has now lost 5.19% against the US Dollar in 2018 and 2.99% against Pound Sterling, although it has fallen further than that in recent months, because it had risen by similar measures during the first quarter of the year.

Wednesday's inflation numbers were of increased importance to the Australian Dollar given the extent to which the currency has been dented this year by a Reserve Bank of Australia that has sat on its hands even as central banks elsewhere in the world begin to raise their interest rates or otherwise withdraw post-crisis stimulus from economies.

"Australia’s economy is not generating inflation pressures strong enough to make the RBA change the current monetary policy outlook. AUD/USD should remain range‑bound for now. Australia’s Q2 terms of trade data is releasedtomorrow. The terms of trade data are significantly important for the medium‑term valuation of AUD," says Richard Grace, chief currency strategist at Commonwealth Bank of Australia.

The Reserve Bank of Australia has held its interest rate at a record low of 1.5% for 23 consecutive months, citing below-target inflation and a debt laden household sector that it says is ill-equipped to handle the pressures of higher borrowing costs given years of weak wage growth. Few see a change in policy until at least the middle of 2019.

The Aussie has long enjoyed support from interest rates that were typically higher than those elsewhere in the developed world, although it no longer has any interest rate advantage over the US and Canadian Dollars, while the UK-Australia yield gap will also narrow if the Bank of England meets expectations and raises interest rates next week.

"AUD/USD recently sold off to, tested and bounced off the .7310/15 recent lows. The strong rebound from here implies a reluctance to break down further currently and we are going to have to neutralise our view for now. Following such a strong rebound on Friday, we are going to have to allow for a recovery to the 55 day ma and recent high at .7476/84. This guards the downtrend at .7539," says Karen Jones, head of technical analysis at Commerzbank.

AUD: Trade War Threat Hangs in the Air

Both Commonwealth and Commerzbank have a relatively pessimistic view of the Australian Dollar but Cole and the RBC FX team advocated earlier this week that clients of the bank actually bet against the currency.

This was in part because of a downbeat outlook for monetary policy, but also because the Australian economy is caught in "trade war" crossfire between the US and China.

President Donald Trump and the US are engaged in a tit-for-tat tariff fight with China, which is Australia's largest trade partner, and the European Union over allegations of unfair trade practices.

The White House recently ordered that a range of tariffs be levied against imports of more than $250 billion in American imports of Chinese goods, and has threatened to target the full $500 billion of goods that China exports to the US each year. It also imposed levies on EU steel and aluminium, drawing retaliatory tariffs on jeans, Harley Davidson motorcycles and a range of other products.

Fears are that a tariff fight between the world's largest economies will quickly descend into an all out "trade war" and that this will dent economic growth in all countries it touches. However, the consequences would be especially pronounced for Australia given its close economic links with China, the Aussie's positive correlation with commodity prices that tend to fall when global growth is threatened.

President Trump and European Commission chief Jean-Claude Juncker will meet in Washington Wednesday to discuss, among other things, trade relations in the hope that an agreement to avoid a further escalation of the tariff spat can be reached.

This is important because President Trump said in May the US is considering a "section 232" investigation into whether the automotive industry landscape presents a threat to US national security. This is the same process used by the White House in 2017 and 2018 as a pretext to imposing tariffs on aluminium and steel imported into the United States.

Fears are that it will eventually lead the US to raise its tariffs on cars entering the country, which could have far reaching consequences for the EU as well as North American Free Trade Agreement countries. The Australian Dollar would also find itself treading water, or submerged in fresh losses, in such a scenario.

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