The Australian Dollar continued to recover for a second week, bolstered by better-than-expected inflation data and firming market-wide risk appetite. The former weighed against RBA interest rate cut expectations while the latter fueled demand for higher-yielding assets, offering support to the sentiment-linked currency. Looking ahead however, upside follow-through may be compromised as a relentless stream of high-profile event risk promises to unleash sharp volatility.

Fundamental Forecast for the Australian Dollar: Neutral

On the domestic front, the RBA monetary policy announcement is in the spotlight. Policymakers are widely expected to keep things as-is for now, with the priced-in probability of a cut registering at a paltry 6 percent. This will put the onus on the statement released following the meeting and the forward guidance contained therein.

Australian economic newsflow has markedly improved relative to consensus forecasts since early December but external threats – notably from instability in China – remain an important downside risk. With that in mind, Governor Glenn Stevens and company may opt for the status quo. This implies a neutral, data-dependent posture that offers little by way of near-term direction cues to the Aussie Dollar.

Turning outward, Chinese PMI figures will inform investors on the health of Australia’s largest trading partner. While measures of manufacturing and service sectors’ activity are expected to tick slightly lower, both outcomes are seen printing broadly in line with near-term trend averages. Absent a major disappointment, it seems unlikely that these outcomes are likely to meaningfully alter RBA policy bets, particularly with the central bank’s own policy update on the docket. That means a lasting response from the Aussie is probably unlikely.

On balance, this paints US newsflow and its implications for broad-based sentiment trends as the most significant volatility risk. The PCE measure of inflation – the Fed’s preferred gauge – as well as January’s employment report will cross the wires. The FOMC attempted to strike a balance between acknowledging recent market volatility and a relatively steady outlook for mandate fundamentals in this year’s first policy statement. Traders interpreted the outcome as dovish however, as we suspected might be the case. The markets could become asymmetrically vulnerable to event risk that rekindles fears of a Fed rate hike in March in this environment.