-By-elections raise Aussie political uncertainty, threaten tax cuts.

-Come as inflation forecasts downgraded, dampening the AUD outlook.

-RBA now to hold rates at record low until end of 2019, challenging AUD.

© AlexanderZam, Adobe Stock

The Australian Dollar outlook darkened Monday as markets awoke in Europe to discover voters have rejected Prime Minister Malcolm Turnbull's economic agenda in a series of by-elections, just as Westpac economists downgrade their forecasts for inflation, dealing another blow to the Australian Dollar outlook.

Australians voted decisively to reject PM Turnbull and the Australian Liberal-National Party coalition's policy agenda of corporate tax cuts on Saturday when they elected four opposition Labour MPs and an independent to fill five seats that were up for grabs in special by-elections.

The vote continues a century-long trend of non-government members winning out in by-election polls and leaves PM Turnbull with continued one seat majority in parliament. While the parliamentary numbers have not changed, the result still leaves Turnbull damaged after the PM made his corporate tax agenda a centrepiece of the Liberal election campaign.

"The ALP victories in the Queensland and Tasmanian contests have reinforced opposition leader Bill Shorten’s position. A general election in 2018 seems less likely now. Given the centrality of company tax cuts for large businesses in the ALP campaigning rhetoric, the Government may come under pressure to adjust its policy in this area," says David Plank, head of Australian econonomics at Australia & New Zealand Banking Group (ANZ).

PM Turnbull had pledged to cut corporate tax rates from 30% to 25%. With all other arguments aside, corporate tax cuts do almost alway offer a short-term boost to growth and so fresh question marks over whether the policy will ever be implemented are a negative for the economy and Australian Dollar.

Although the election upset is just one out of a long line of nails to have been hammered into the Aussie's proverbial coffin during recent months. Another nail came on Monday, in the form of Westpac's downgrades to its forecasts for Australian inflation during the months ahead, which make the prospect of an eventual Reserve Bank of Australia (RBA) interest rate rise seem even more distant.

"The resulting impact of these changes is that we now forecast headline inflation to remain below 2.0%yr out to the end of 2019 (our forecast is for 1.7%yr at end 2019). That is correct; not only do we not expect inflation to return to the mid point of the target band but we don't expect it to get back into the band," says Justin Smirk, a senior economist at Westpac.

Australian Comptetition and Consumer Commission officials recommended a series of government actions earlier this month that are designed to reduce the cost of household energy bills. This comes at the same time as wholesale electricity prices are trending lower in Australia, given an sharp increase in renewable power generation at the domestic level.

"This is a game changer. Until recently we had expected that rising electricity prices would remain a meaningful inflationary pulse at least through 2018 and possibly into 2019," explains Smirk. "We expect electricity prices to fall through 2018 and the first half of 2019."

Currency markets care about the inflation data because consumer price pressure have a direct bearing on the interest rate and other monetary policy decisions of the RBA, and it is changes in rates themselves that are the raison d'être for most moves in exchange rates.

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.

Smirk and the Westpac team say that, because below-target inflation will persist for longer than previously expected, the Reserve Bank of Australia is now likely to keep its interest rate at a record low of 1.5% all the way until the end of 2019.

This is a double negative for the Australian Dollar in today's market given that other central banks are expected to carry on raising their own interest rates in the interim period.

The Aussie has long enjoyed support from interest rates that were typically higher than those elsewhere in the developed world.

However, the deterioration of the outlook for Aussie interest rates, at a time when the US Federal Reserve and other central banks are raising their own rates, has incentivised investors to sell the Australian Dollar in favour of buying Pounds, US Dollars and other currencies.

As a result, 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.

"Our forecasts incorporate some pass through from a weaker AUD through the next two years. Any lack of such pass through presents a downside risk to both our headline and core inflation forecasts," says Smirk.

The AUD/USD rate was quoted 0.04% higher at 0.7401 during early trading Monday while the Pound-to-Aussie rate was up 0.35% at 1.7736. It was also down against all developed world currencies except for the Pound, Euro and New Zealand Dollar.

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