AUD Retail Sales (DEC) (00:30 GMT; 19:30 EST)
Expected: 0.6%
Previous: 0.8%

RBA Rate Decision (03:30 GMT; 22:30 EST)
Expected: +25bp to 7.00%
Previous: No Change at 6.75%

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 may exhibit their hawkish bias with a rate hike. Indeed, there is a considerable probability for a quarter point rate increase to 7.00 percent in the market and among economists’ forecasts. The fundamental reasoning behind this scenario is firmly anchored in both growth and inflation. The Australian economy is working on its sixteenth consecutive year of growth. For a more timely reading on expansion, recent data has shown: November retail sales were stronger than expected, posting a 0.8 percent matching gain; the net change in employment was positive for the 14th straight month; the jobless rate remains near a 33-year low; house prices jumped 12.3 percent in the fourth quarter from a year earlier; and the December trade deficit narrowed as mining exports rose on Chinese and Indian demand for commodities. The most critical piece of evidence remains the persistent price pressures in the economy, as the RBA’s weighted-median index of inflation jumped 1.1 percent in the fourth quarter, pushing the annual rate of growth to a 16-year high of 3.8 percent. With CPI expected to hold above 3.0 percent during the first half of 2008 as well, 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.” As such, the meeting is likely to generate price action across the Australian markets whether the news confirms expectations with a hike, or disappointing them with no change.

Bonds – 10-Year Australian Government Bond Futures

Australian government bonds ran headlong into resistance at the 94.20 level, which has capped similar rallies over the course of 2007. Indeed, the contract has fallen quite a bit as traders ramp up speculation that the bank will raise rates in February. Upcoming data could weigh on AGBs further in anticipation of the meeting towards 93.80. On the other hand, if Australian equity markets reverse and tumble, the subsequent risk aversion could lift AGBs towards 94.20 once again.

FX – AUD/USD

This week’s RBA rate decision provides substantial even risk for the AUD/USD pair, and a 25bp hike would be the only means for an Aussie dollar rally. However, traders should not be looking merely for a quarter point hike to institute a long AUD/USD trade. If the RBA does indeed raise interest rates, there is a possibility the bank will signal that they will not need to make monetary policy any more restrictive, as evidence of tight global credit market conditions and unstable financial markets could factor into the interpretation of the rate decision. As a result, Aussie could turn away from resistance at 0.9080 and fall back towards 0.8850. Likewise, a surprise decision to leave rates steady would weigh heavily on AUD/USD. On bullish fundamentals which include a hawkish policy statement along with a 25bp hike, the pair will likely make a clear break through near-term resistance to take on 0.9200.

Equities – S&P/ASX 200

While the S&P/ASX 200 has recovered somewhat since tumbling over 24 percent from the November 2007 highs to a low of 5,186.80, fears that a possible US recession and a credit crunch will impair the global financial markets could remain a stress on the index. Now that the Federal Reserve has enacted a total of 125bps in rate cuts over the past two weeks, equity markets in the Asia-Pacific region have stabilized as a sigh of relief. However, the 6,020 level has capped recent rallies, and with the RBA likely to hike, equities could slip once again especially as the overwhelming trend remains to the down side. The next major level of support looms at 5,400 and should prevent further declines in the near-term.

Terri Belkas is a Currency Strategist at FXCM.