RBA Will Remain on the Sidelines, AUD Vulnerable

Signs of a slowdown in the Australian economy will force the Reserve Bank to hold rates unchanged on Tuesday and are making expectations of an August hike vulnerable. The Australian dollar is likely to fall if policymakers do not take strong incremental steps toward future rate hikes.

At 0430 GMT, all 28 economists surveyed by Bloomberg expect the RBA to leave interest rates at 4.75%. Yesterdays unexpected drops in retail sales and inflation cemented those expectations and are cutting into the chance of an August hike.

May retail sales fell 0.6% compared to the 0.3% rise expected. At the same time, the Melborne Institute/TD Securities monthly inflation gauge was flat in June after a 0.2% rise in May; the annual rate fell to 2.9% from 3.3%. Building approvals also slumped 7.9%.

At the previous meeting, on June 6, the market had priced in a 16% chance of a hike. When it didnt come, AUD/USD fell 60 pips to 1.6080. The pair eventually bottomed at 1.0390 on June 26 but popped back to 1.0775 during last weeks risk rally. Whats critical from a fundamental and technical perspective is that the pair has failed to close above 1.0774 -- the high before Junes unexpectedly dovish RBA statement. This will be a key closing level in the day ahead.

The market is still hanging on to the idea that the RBA could hike in August but we see it as a long shot. We also expect the chance of a hike in August to fall to virtually nil if the RBA continues to say: The Board judged that the current mildly restrictive stance of monetary policy remained appropriate. The OIS market is pricing in just 15 bps of tightening in the next 12 months.

Given that, AUD/USD is looking rich at the moment (1.0732). Even if the RBA introduces slightly more constructive rhetoric, we think the rally will be short-lived (48 hours max). It will take a significant hawkish shift to propel AUD back toward a re-test of the all-time highs at 1.10. This would manifest itself in something like the Feb. 2010 statement which said: The Board considers it likely that monetary policy will, over time, need to be adjusted further in order to ensure that inflation remains consistent with the target over the medium term.

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