RBA’s Confidence in Slaying Disinflation Doubted by Bond Market

  • Swaps indicate traders expect inflation will hold below 2%
  • Current policy is consistent with inflation goal, RBA says

Australian fixed-income investors are showing skepticism that the inflation rate will rise back to the central bank’s target range without more cuts to benchmark borrowing costs.

Traders of inflation swaps have been betting since before this month’s policy meeting that the pace of consumer-price gains will hold below the Reserve Bank of Australia’s preferred band of 2 percent to 3 percent over the next five years. That contrasts with the RBA’s view that its decision to keep the cash rate unchanged at 1.75 percent was consistent with the pace of inflation moving back to target “over time.”

While bond yields have rebounded this week as the odds of a British exit from the European Union have decreased, that shift has done little to budge expectations for Aussie consumer prices. Global disinflationary pressures are weighing on the outlook even as unemployment remains in check, and overnight index swaps indicated a 59 percent probability of another RBA rate cut this year as of 9:30 a.m. Thursday in Sydney. The next official consumer price index release is scheduled for July 27.

Easing Bias

“I think low inflation outcomes are embedded into market expectations of RBA policy,” said Damien McColough, head of fixed-income research at Westpac Banking Corp. in Sydney. “While the probability of another cut might be scaled back if the U.K. opts to stay in the European Union, the easing bias is still baked in. The next inflation reading will be crucial for RBA direction.”

The following charts highlight the market’s expectations for inflation, the downward pressures that the RBA faces and the likelihood of additional monetary stimulus.

CHART 1: The five-year inflation swap has held below 2 percent for most of this month, while the breakeven rate based on pricing of inflation-linked bonds hasn’t been above that level since December.

CHART 2: Official consumer-price data showed that the RBA’s preferred measures of core inflation fell to record lows last quarter, prompting the central bank to lower its key rate by a quarter point in May. A private monthly gauge compiled by the Melbourne Institute indicates that disinflationary pressures have continued to build in the second quarter.

CHART 3: Traders are pricing in a quarter-point reduction from the RBA in the coming year, according to interbank futures.

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