TD SECURITIES: Here's how markets will to react to Australia's inflation report no matter what the outcome

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Australia’s September quarter consumer price inflation (CPI) report is about to be released.

It’s probably the most important domestic data release that we’ve seen since the last inflation report was released in late July, taking on increased prominence given the knowledge that the past two reports have been directly followed by a rate cut from the RBA.

Of most importance to markets will be the core, or underlying, CPI figure — an average of the weighted median and trimmed mean readings released by the ABS.

It is this figure that will drive Australian interest rate expectations, hence movements in the broader financial markets.

In a poll conducted by Bloomberg, the median economist forecast looks for a quarterly increase in core inflation of 0.4%, something that will see the year-on-year rate accelerate to 1.55% should that view be proven correct (along with no revisions to prior data).

Now strategists are now taking over, attempting to uncover how markets are likely to react no matter how the core figure prints.

Those at ANZ have had their say, and now TD Securities has also chimed in, producing an excellent synopsis of how financial markets are likely to behave.

Here’s the view of Annette Beacher, TD’s chief Asia-Pacific macro strategist, on what she expects from today’s report, even attaching a probability of each individual scenario occurring.

For clarity purposes, dovish indicates a weak core inflation figure, while a hawkish result means a higher-than-expected number. Neutral, as the name suggests, will do little to sway interest rate expectations one way or another.

Here it is:

NEUTRAL (35%): a “consensus” quarterly core CPI increase of +0.4%/qtr and 1.55%/yr is ‘as expected’ and cements the case for another cash rate pause at 1.5% at next Tuesday’s RBA Board meeting. The RBA already projects underlying inflation to be 1½%/yr this year, and RBA Governor Lowe has expressed that there is ample policy ‘flexibility’ when it comes to inflation tracking below the Bank’s 2-3% inflation band. ‘As expected’, however, could still briefly lift the AUD and short bond yields as the risk of a cut next week shrinks even further to near-zero (OIS currently 15%). TD attaches a 35% probability to this scenario.

Slightly DOVISH (55%): A quarterly core CPI print closer to our +0.3%/qtr forecast may be “below consensus” but with the annual rate still printing at 1.5%/yr, does not provide a trigger for the RBA to cut next week. However, a ‘below market’ print could see the OIS profile for 2017 increase the risk of another cut (currently barely 50/50 by mid-2017) and puts modest downward pressure on the AUD, towards $US0.76. Our favoured scenario therefore sees modest 2-5yr curve flattening and a lower AUD and TD attaches a decent 55% probability.

Very DOVISH (5%): A flat or slightly negative core print provides the biggest headache for the markets and the RBA. It was the significant -0.5%pt downside miss earlier this year (1.5%/yr vs widespread 2%/yr expectations) that prompted the “shock” May RBA cut, and a similar downside miss will test the RBA under Dr Lowe. Will the Bank cut again next week on such a significant downside miss (1%/yr vs 1.5%/yr expected) or is 1% within Dr Lowe’s tolerance? We can see OIS pricing the risk of a 1 November cut jumping well past 50% on this outcome, and trading closer to 100% to 1.25% for the February 2017 RBA Board meeting (as long as the Q4 CPI report remains benign to actually pull the trigger). Short bond yields in this case can easily retest sub-cash levels while the AUD could plunge to $US0.74 (risking the May lows of $US0.72). While this is the most dislocating outcome for the financial markets, TD only attaches 5% to this scenario.

HAWKISH (5%): An average quarterly print of +0.6%/qtr or higher means a minimum 1.75%/yr, and hence offers modest upside compared with the RBA projection of 1.5%/yr (if 1.5%/yr is taken literally). This hawkish outcome not only cements the case for pausing next week, the OIS curve could steepen dramatically. Why? When the RBA eventually hints at a diluted easing bias, the markets tend to swiftly shift to pricing “the next move is up” for the cash rate. On this scenario, 3yr bond yields jump past 1.80% towards 1.90%, and the AUD could easily retest April’s $US0.78 cyclical high. However, with low wages growth and ample spare capacity still in the economy, we only attach a 5% probability to this scenario.

Beacher, as indicated by the commentary above, believes that the most likely scenario is for the core inflation figure to come in slightly below consensus.

This, she says, will probably not be enough to warrant a rate cut from the RBA this year, but will see the odds of a rate cut in 2017 firm.

“Even if our slightly-below-consensus core forecasts come to pass, there is a strong case for the RBA to remain on hold at 1.5% for next week’s RBA Board meeting,” she says.

“However, as the door remains open for a cut, we see OIS being slightly underpriced for a cut next year, currently barely 50/50 by mid-2017.”

The report is scheduled to be released at 11.30am AEDT.

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