18.02.202612:52 Forex Analysis & Reviews: RBA flags inflation risk, AUD/USD set to extend gains

Markets are calm as US economic activity is reduced after the Presidents' Day holiday and there are no major economic releases, while much of Asia, including China, is already on holiday for the Lunar New Year. However, activity may pick up noticeably from today.

The minutes of the Reserve Bank of Australia's last meeting said the board judged there had been a considerable shift in the balance of inflation risks that warranted a quarter-point increase in the policy rate to 3.85%.

The board was not certain whether further tightening would be required, but it stressed that inflation has exceeded the target for three years and that financial conditions remain insufficiently tight to restrain excess demand. In effect, this means the RBA has signaled readiness to raise rates further if inflation does not show signs of slowing in Q1. Markets now price roughly a 60% probability of a 25 bp hike in May and are fully confident of a further increase by August.

The inflation threat in Australia appears to be intensifying. The IMF has warned that Canberra's 5% down-payment program for home buyers will, for the first time, push up housing inflation and should be scrapped. The RBA had warned of such risks months ago, but now even the bank appears surprised that it may need to revise its outlook. This comes as the Fed also plans to ease bank capital requirements to try to stimulate mortgage lending at lower rates.

Australia's labor market report will be published on Thursday, and the January consumer price index on Monday. The CPI release will probably be the most market-sensitive item: it will either confirm concerns about rising inflation and, accordingly, a further RBA rate increase, or relieve pressure if it is weaker than expected—in which case the Aussie would retrace slightly.

Net long positioning in AUD rose by $0.5 billion over the reporting week to $2.4 billion. Demand for the Australian currency has been trending up for 11 weeks, speculative positioning has become more bullish, and the implied price continues to rise steadily.

AUD/USD hit a three-year high at 0.7150. The corrective pullback is shallow, and there is every reason to expect the rally to resume after a short pause. Support is at 0.6949, but a retracement to that level is unlikely unless January inflation on Monday shows a marked slowdown. A more likely scenario is continued upside and a break of the 0.7150/60 resistance zone—technically, that would mark a strengthening of the bullish impulse, although the probability of a correction increases after such a breakout.