RBA Weighted-Median (YoY) (Q4) (00:30 GMT; 19:30 EST)
Expected: 3.4%
Previous: 3.1%

Consumer Prices (YoY) (Q4) (00:30 GMT; 19:30 EST)
Expected: 3.0%
Previous: 1.9%

What Are The Markets Facing?

If the Federal Reserve is dovish and aggressively cutting rates, the Reserve Bank of Australia is quite the opposite, and upcoming inflation data will highlight why. The RBA’s annualized weighted median measure of consumer prices for Q4 is expected to rebound to a 16-year high of 3.4 percent, and this figure is actually excluding the largest price gains and declines. Meanwhile, the headline CPI figure is forecasted to jump up to 3.0 percent from 1.9 percent. Indeed, rallies in the cost of food, energy, and raw material products have raised upside inflation risks globally, and Australia is no exception. However, the country has other issues to grapple with as well, given the fact that consumption has proven to be highly resilient, with retail sales for the month of November stronger than expected as the labor market has already taken on additional workers for 14 consecutive months. Meanwhile, a lack of availability of skilled workers at mining companies creates the potential for faster wage growth, which the Reserve Bank of Australia will see as a threat to price stability. With CPI expected to hold above 3.0 percent during the first half of 2008, it’s no wonder the central bank holds such a hawkish bias. In fact, in the policy statement from the RBA’s December meeting, Governor Glenn Stevens noted that “recent information continues to indicate strength in demand and output in Australia, with the economy having relatively little surplus capacity.” While the Board remained “concerned about the outlook for inflation,” increased “uncertainty about the international outlook and the local trends in wholesale borrowing costs” left the RBA to judge that “the current stance of monetary policy should be maintained for the time being.” Though the global outlook for growth remains uncertain and credit conditions have tightened somewhat domestically, they are no where near “crunch” conditions and as a result, the RBA may be more comfortable considering rate hikes. While the bank does not meet again until February 5 and data released before that time may indicate changing conditions, surprisingly strong inflation readings will lead the markets to aggressively ramp up expectations for a 25bp rate increase to 7.00 percent.

Bonds – 10-Year Australian Government Bond Futures

Australian government bonds have run headlong into resistance at the 94.20 level, which has capped similar rallies over the course of 2007. Furthermore, the contract could be in for additional declines towards 93.85 if Australian inflation data proves to be stronger than expected. Indeed, with the RBA already concerned about building prices pressure, confirmation of their fears will lead traders to ramp up speculation that the bank will raise rates in February. On the other hand, if Australian equity markets continue to tumble, the subsequent risk aversion could lift AGBs towards 94.20 once again.

FX – AUD/USD

As a commodity currency, it has been interesting to see that the rapid ascent of gold prices hasn’t had a bigger impact on the Australian dollar. Nevertheless, AUD/USD declines have paused above 200 SMA support at 0.8602 with the help of a surprise 75bp rate cut by the Federal Reserve on Tuesday. Looking at upcoming event risk, the release of Australian inflation data could propel AUD/USD higher as the figure is expected jump, and if the annual CPI results are actually stronger-than-expected, the rally could be sharp as the markets may ramp up speculation that the RBA will move to hike rates in February while most other central banks are reducing interest rates or at least considering cutting rates. On the other hand, soft inflation readings could weigh on AUD/USD, with a break below 0.8600 targeting 0.8330.

Equities – S&P/ASX 200 Index

The S&P/ASX 200 has tumbled over 24 percent from the November 2007 highs, with the most significant losses occurring over the past week amidst fears that a possible US recession and a credit crunch will impair the global financial markets. However, now that the Federal Reserve has enacted a surprise cut, equity markets in the Asia-Pacific region could stabilize – albeit very briefly – as a sigh of relief. On the other hand, the release of Australian inflation data could weigh equities down further, especially as the overwhelming trend remains to the down side. The next major level of support looms at 5,000, which also happens to be a psychologically important level and should prevent further declines in the near-term.

Terri Belkas is a Currency Strategist at FXCM.