- AUD runs on fumes after U.S. CPI delivers fleeting lift

- As coronavirus closures broaden out across economy

- Imperilling medium-term expectations of RBA policy

- Weighing on AU yields, disincentivizing bids for AUD

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GBP/AUD reference rates at publication:Spot: 1.8885Bank transfer rates (indicative guide): 1.8190-1.8322Money transfer specialist rates (indicative): 1.8680-1.8718More information on securing specialist rates, hereSet up an exchange rate alert, hereThe Australian Dollar remained a laggard in the penultimate session of the week as broadening coronavirus-inspired business closures and curbs on social contact cast a tall shadow of the outlook for Reserve Bank of Australia policy that could keep GBP/AUD supported and AUD/NZD suppressed for a while yet.

Australia’s capital Canberra was the latest to be thrown into lockdown on Thursday after city officials discovered their first case of the coronavirus, although containment measures were also expanded in New South Wales to further surrounding areas of Sydney, with these coming barely a day after the shutdown in Melbourne and hard on the heels of a sixth all-out closure of the second largest state level economy Victoria.

Canberra’s officials have so far declared only a seven-day shut-in but precedent from elsewhere in Australia has been for these periods to be extended repeatedly, in line with the experience of other countries including the UK, and so the latest wave of infection is placing an ever larger question mark over the prospects of the national economy with knock-on implications for the Reserve Bank of Australia (RBA) monetary policy outlook.

For the Australian Dollar the result has been a continued underperformance against many currencies including the U.S. Dollar, Sterling and the New Zealand Dollar among others, which has seen AUD/USD and AUD/NZD proving unable to sustain corrective rallies and has kept GBP/AUD elevated above 1.88 through most of the current week.

“AUD is unlikely to sustain its gains in the face of the current Covid situation in Australia,” says Joseph Capurso, head of international economics at Commonwealth Bank of Australia. “The Australia-US 10 year bond spread widened briefly to -17bp in the Asia session.”

Above: AUD/USD shown at 4-hour intervals with GBP/AUD and AUD/NZD.

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Capurso and the CBA team have flagged as a major headwind for the Australian Dollar the ongoing fall below zero by the spread, or gap between the 10-year government bond yields of Australia and the U.S., which is acting as a disincentive for investors who might otherwise buy the currency.

That spread fell briefly to -0.17% in the early hours of Thursday before correcting higher, although CBA’s bond market strategists forecast a further decline to -0.25% in the coming months, which could potentially push AUD/USD as far as 0.70 in some scenarios according to bank’s research.

A tripartite of factors have been driving this forecast and the subsequent developments including global economic headwinds arising from the deteriorated coronavirus situation across many parts of Asia, a strong performance from the U.S. economy that is steadily introducing into the global market picture a gradual paring back of Federal Reserve (Fed) support for the U.S. economy and Australia’s own broadening economic headwinds.

“We believe this will continue over coming weeks, with outperformance most notable on US-led [bond market] sell-offs. With Sydney’s lockdown extending to the regions, fears around the pandemic remain the dominant near term focus as well as driver of market valuations and price action, and clearly the economic risks remain stacked to the downside,” says Damien McColough, head of rates strategy at Westpac.

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Australia’s latest coronavirus outbreak had been seen by many back in July and earlier this August as the lesser of above referenced factors, although the recent broadening of restrictions to ensnare increasingly large parts of the economy, as well as prolongation of measures in other parts has grown in weight and could yet burden the Australian Dollar further in the weeks ahead if it leads the market to revise medium-term expectations for RBA policy.

“The recent AUD rates outperformance, where 10yr bond yields have fallen by 60bp since May '21, is best explained by the broader lockdowns across Australia from the Delta variant,” says Phear Sam, a rates strategist at BofA Global Research.

“In our view, the AUD rates market is drawing closer towards an important juncture where it needs to decide on whether to unwind excessive 10y risk premium or push back on the timing of RBA rates lift-off,” Sam writes in BofA research note this week.

Australia’s central bank surprised the market earlier this month when it opted to push ahead with earlier plans to reduce the amount of government bonds bought each week under its quantitative easing programme, from A$5BN to A$4BN is September, which may have played a role in preserving investor expectations for an increase in the official cash rate during the year ahead.

Above: AUD/USD shown at 4-hour intervals with GBP/AUD and AUD/NZD.

Pricing in the overnight-index-swap market for interest rate derivatives - popular tools used by companies and investors to insure themselves against or to wager on interest rate changes - still suggested this week that investors think there’s a substantial chance of the cash rate being lifted from 0.10% to 0.25% before the end of 2022 which in turn implies a market expectation that the RBA will stick to its timeline for tapering QE over the coming months.

“For Australia, the way out from lockdowns and a view on the length of the impact on economic activity comes from how quickly vaccination rates rise,” says BofA’s Sam. “If the current pace of acceleration can be maintained, then 70% can be reached by mid-November. However, each State has individual thresholds to reach in order to ease restrictions, which suggests the reopening may be uneven.”

Australia’s Dollar had received a boost on Wednesday when U.S. inflation data suggested the 2021 acceleration of price growth in the world’s largest economy may be cresting, but despite this the Fed is still widely perceived as likely to go ahead with a tapering of its own quantitative easing programme in the coming months while the RBA’s path toward a lesser footprint in the Australian government bond market is less assured.

For the currency this could easily translate into a continued handicap for the main Australian Dollar exchange rate AUD/USD which would, in the absence of any setbacks for Sterling or the Kiwi, keep the Pound-to-Australian Dollar rate supported and AUD/NZD suppressed in the weeks ahead.

“The AUD has managed to avoid another test of the lows below 0.7300 despite Fed commentary fairly clearly pointing towards taper plans being laid out in the weeks ahead and iron ore’s sharp correction. And signs that we have passed peak inflation in the US has helped a retest of the key 0.7370/90 region. That leaves us with a slightly confused picture near term,” says Richard Franulovich, Westpac’s head of FX strategy.