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The Australian Dollar could shoot higher on Tuesday on a non-negligible chance the Reserve Bank of Australia (RBA) defies expectations to hold interest rates unchanged.
Markets are positioned for the first 25 basis point interest rate cut of the RBA's easing cycle on Tuesday, but some analysts warn this is not a done deal.
"We acknowledge the risk of a hawkish surprise by the RBA, either by keeping the cash rate unchanged at 4.35% or via cautious guidance from Governor Bullock at the press conference," says Nicholas Chia, FX and Macro Strategist at Standard Chartered.
The Australian Dollar is currently at levels consistent with a cut on Tuesday, meaning it will rally if the RBA surprises and opts to hold rates.
"Despite weak private-sector job creation, the RBA may cite a still-tight labour market and elevated underlying price pressures to signal a shallower rate-cutting cycle in 2025," says Chia.
Analyst Jeremy Stretch at CIBC Capital Markets says the risk of unexpected inertia at the RBA is actually larger than money market pricing currently suggests.
He cites, in particular, an uptick in inflation expectations to 4.6% in the latest MI survey, up from 4.0%, (the 0.6% monthly advance represents the biggest jump since June 2022).
"Although the outlook for growth is slowing, there is no cause to suggest that the economy is in dire need of a rate cut or aggressive easing cycle," says Stretch.
Australia's labour market continues to exhibit strength, with low unemployment rates and steady job growth. A tight labour market can lead to wage increases, potentially fueling further inflation. The RBA might opt to hold interest rates steady to prevent the economy from overheating and to maintain control over inflationary pressures.
Above: Money markets have been wrong-footed by the RBA before as it pushes back against expectations for rate cuts. Image courtesy of Goldman Sachs.
"Despite weak private-sector job creation, the RBA may cite a still-tight labour market and elevated underlying price pressures to signal a shallower rate-cutting cycle in 2025," says Chia.
"On AUDUSD, a hawkish cut by the RBA may nudge the pair above the 0.64 level," he adds.
Even if the RBA does proceed with a cut, there is still a route to a stronger Aussie Dollar via 'hawkish' guidance that warns against expecting follow-through cuts in a timely manner.
"Should it be deemed a hawkish cut, via pushing back cumulative rate cut pricing, another 54bps is priced by September, could encourage AUD support," says Stretch.
Despite a decline in headline inflation to 2.8% in the September quarter of 2024, underlying inflation remains elevated at 3.5%, exceeding the RBA's target range of 2-3%.
Above: Australian inflation, source: ABS.
This persistent core inflation would suggest the central bank has reason to prevent financial conditions from loosening too much, as would be the impact of a market that moves to price in the next rate cut before September.
"Since the RBA has not raised rates to particularly restrictive levels, we expect a fairly shallow cutting cycle even as cuts are pulled forward in 2025. This policy path should remain supportive for the AUD," says a weekly strategy note from Barclays.
Analysts at Bank of America expect the RBA to cut the cash rate target by 25bp, in line with consensus and market pricing.
However, "the statement and press conference are likely to suggest a gradual approach to easing. Risk is for a hold in February," says Bank of America economist Nick Stenner. His FX research colleague, Oliver Levingston, thinks the Aussie Dollar is nearing a trough against the U.S. Dollar and that a rebound will evolve in the coming months.
"We continue to see a gradual recovery in AUD from 2Q onward, propelled first by USD depreciation followed by the lagged impact of China stimulus in the second half of '25," he says.