Markets continue to weigh up inflation risks as AUD to correct lower

Weaker CPI report hits Aussie but underlying details are less favourable.

Yesterday morning, the Australian and New Zealand dollars experienced significant movements, with both currencies performing poorly following the release of a weaker-than-expected Australian CPI report.

Consequently, AUD/USD retreated towards the 0.6600-level, while NZD/USD approached the 0.6100-level. The primary catalyst for the sharp selloffs was the May Australian CPI report, which indicated that headline inflation had slowed more than anticipated, dropping by 1.2 percentage points to an annual rate of 5.6%. This decline further distanced the inflation rate from its peak of 8.4% at the end of the previous year. The decline in the headline inflation rate can be attributed to favourable base effects resulting from lower fuel prices and a significant decrease in travel expenses. Fuel prices in May recorded a decrease of 6.7% compared to a 11.0% increase in May of the previous year, subtracting 0.6 percentage points from the annual headline rate. Likewise, holiday travel and accommodation experienced a sharp decline of 11.3% in May, particularly noticeable in domestic travel, which fell by 15.5%. Although the RBA might find some solace in the substantial drop in the headline rate, the underlying details of the report were less favourable.

CORE CPI MEASURES DID NOT SLOW AS MUCH AS HEADLINE

Source: Bloomberg, Macrobond & MUFG GMR

Core inflation measures have peaked but remain at elevated levels.

The trimmed mean measure of core inflation slowed by 0.6 percentage points, reaching an annual rate of 6.1%, further deviating from its peak of 7.2% in December. The RBA also considered the measure of inflation excluding fuel, fruit & vegetables, and travel, which only marginally decreased by 0.1 percentage point to 6.4%. The persistent evidence of heightened inflation pressures in the service sector is a cause for concern for the RBA, even with the significant drop in the headline rate. Consequently, I’m still anticipating further rate hikes by the RBA, although it is now possible that they may choose to skip the upcoming policy meeting next week and instead maintain rates until the subsequent meeting in August. The minutes from the RBA's previous meeting earlier this month already indicated a close decision regarding rate hikes. As a result, the Australian rate market has adjusted to reflect a lower probability of consecutive 25-basis-point hikes next month. Currently, the market has priced in approximately 7 basis points of hikes for the July meeting and 19 basis points for the August meeting. The likelihood of a final hike in the cycle, reaching a peak of 4.60%, is now viewed as more finely balanced, with 37 basis points of hikes priced in by December. Overall, this represents another setback in the near term for the Australian dollar, which has been undergoing a corrective decline since mid-month.

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