- AUD gains fade after inflation bounce seen as not enough.

- Inflation rises faster than expected but RBA still to cut rates.

- An RBA hold in February would give way to cut at later date.

- And RBA cut next week would leave AUD badly wounded.

- After market all but prices out a February 04 RBA rate cut.

- Coronavirus adds to multiple headwinds weighing on AUD.

Above: Governor Philip Lowe. Photo: O'Neill Photographics/Goldman Sachs. Source: RBA on Flickr, reproduced with permission from the RBA press office.

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Australia's Dollar softened Wednesday despite an upside surprise in final quarter inflation numbers, as markets contemplated whether the rapidly spreading coronavirus might still prompt the Reserve Bank of Australia (RBA) to cut the cash rate for a fourth time next Tuesday.

The Pound-to-Australian Dollar rate was higher Wednesday as investors eschewed the Aussie ahead of next week's decision from the RBA, and as markets digested the latest coronavirus disclosures from China.

This was despite stronger-than-expected inflation figures that might have been enough to sustain a lift in the Aussie during ordinary times

Inflation rose 0.7% in the three months to the end of December when markets looked for only a 0.6% increase. That lifted the annual rate of price growth from 1.7% to 1.8%, close to the lower end of the RBA's 2%-to-3% target. However, the RBA's preferred 'trimmed mean' measure of prices rose just 0.4% and by a meagre, as well as unchanged, 1.6% on an annual basis.

"We see plenty of reason for the RBA cutting on 4th Feb. So from a risk-reward perspective and given how little is priced for a rate cut on 4th February we see greater potential for AUD downside from here over the short-term despite the drop we had on Monday," says Derek Halpenny, head of research, global markets EMEA and international securities at MUFG.

Above: Pound-to-Australian-Dollar rate shown at 4-hour intervals.

Wednesday's inflation data briefly encouraged some investors to believe that a rate cut next Tuesday is now even less likely than it was in the wake of the latest jobs report, which revealed a surprise fall in the unemployment rate for December. However, an already-weak economy and mounting risks associated with the spread of the coronavirus could mean a fourth RBA cut is now unavoidable and the market is not prepared for such a move any time soon.

Wednesday's 19:00 rate decision and statement from the Federal Reserve (Fed) might provide clues on how others are likely to respond to the coronavirus.

Pricing in the overnight-index-swap market suggested before last week's employment numbers that an RBA rate cut was highly likely next Tuesday although the implied cash rate rose from 0.60% to 0.70% by the weekend. That helped the Aussie to stabilise but the economic risks that now stem from the spread of coronavirus in China, the largest trade partner for Australia's weak and wobbly economy, is now a risk to the antipodean currency.

"AUD/USD inched higher in the Asia session, but remains some 3.7% lower over 2020 to date," says Kim Mundy, a strategist at Commonwealth Bank of Australia. "AUD will struggle to gain against the USD over the next week, despite diminished RBA rate cut expectations. In our view, the relatively strong US economy and ongoing coronavirus concerns will support USD and ultimately be the dominant driver of near–term AUD/USD direction. We still consider 2019’s low – 0.6671 – a good level to watch."

Above: AUD/USD rate shown at 4-hour intervals.

Coronavirus has spread to all 31 of China's provinces, according to the National Health Commission, with the number of confirmed infections rising from 4,515 to 5,974 between Tuesday and Wednesday.

There were 1,239 "severe cases" as of midnight on January 28, up from 917 the previous day, while the number of fatalities increased from 106 to 132. And the number of suspected cases has risen from 6,973 to 9,239.

Furthermore, the virus is now present in at least 17 locations outside of mainland China including Australia, according to UK government figures.

That's testament to the potential the virus has to cause global disruption. In Wuhan of Hubei province, residents are already locking themselves away in order to avoid infection, leading the local economy to grind to a standstill and the city to become a ghost town. And such a thing could easily happen in other Chinese provinces, not to mention elsewhere.

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

"Not cutting would be a mistake and merely delaying the inevitable. In a world of major central banks reviewing monetary policy frameworks due to persistent failures to hit inflation goals as nominal rates fall to zero percent, the RBA should not hesitate in cutting given the global risks. The coronavirus is just one global risk, but trade uncertainties are likely to persist and the unemployment rate may need to fall to 4.5% to lift inflation," Halpenny says.

For Australia the spread of coronavirus could mean the RBA risks controversy if it neglects to cut interest rates next Tuesday, especially as the bank was already worried about the economic and inflation outlooks before the new pneumonia-like virus became a national epidemic in China and arrived on Australian shores.

"The increased risk also follows from the more dominant role of China in the Australian economic mix now than in 2003. The Chinese share of Australian exports, for example, is up from 8% in 2003 to 34% in 2019. The share of Chinese tourist arrivals has increased from 4% to 15% over the same period," says Michael Blythe, an economist at CBA. "China takes 82% of Australian iron ore exports now, up from 32% in 2003. These larger shares magnify the impact of any China negative into the Australian economy. They suggest tourism and education indicators are the early warning signs to watch."

Above: AUD/USD rate shown at daily intervals.

The Australian Dollar is in no way prepare for a cut, not least of all because the nation's banks abandoned forecasts for one after last week's jobs report.

The RBA cut the cash rate three times last year, taking it from 1.5% to 0.75%, in an effort to lift jobs and GDP growth sufficiently for the economy to sustainably deliver the 2%-to-3% inflation target.

That's badly wounded the Australian Dollar, although it would be almost sure to suffer further weakness if the RBA cuts next Tuesday because pricing in the overnight-index-swap market implies a cash rate of 0.67% for next week, which is far below the 0.5% that would prevail after a cut.

"AUD/USD has sold off to the .6755 November low and the 78.6% retracement at .6749, which has held on a closing basis," says Karen Jones, head of technical analysis for currencies, commodities and bonds at Commerzbank. "Failure here will target the .6671 October low. The market will stay directly offered near term while capped by the 200 day ma at .6874."