Should you buy or sell the Australian dollar ahead of the RBA monetary policy decision?

The month ahead is full of important economic events and central banks’ monetary policy decisions that will move financial markets. One is the Reserve Bank of Australia (RBA) decision due on Tuesday, July 5.

The RBA was one of the first central banks to hike the interest rate, or the cash rate target, in response to rising inflation. Yet, it is doing so at a pace that does not match the rise in the interest rate in the United States.

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As such, the cash rate target ahead of Tuesday’s decision is 0.85%, and the market participants expect either a 25bp or a 50bp rate hike. But the bias is that the RBA will choose the most aggressive option and move the cash rate target higher by 50bp to 1.35%.

Australian inflation is much higher than the RBA’s target

According to the RBA, an appropriate target for monetary policy is to achieve an inflation rate in a range of 2%-3% over time. Such an inflation rate gives the central bank enough space to react in an economic downturn and also fuels a steady economic growth rate in expansionary times.

But inflation now exceeds 5% in Australia.

While not so high as in the United States (8.5%) or in the Euro area (8.6%), Australian inflation sits well above the RBA’s target. Hence, the central bank reacted by raising the interest rate, and it will continue to do so until inflation cools down.

AUD remains weak against the US dollar

The interest rate differential is one of the main drivers in the movements of an exchange rate. The exchange rate reflects the value of one currency in terms of another, and by simply comparing the interest rates of the two currencies, one may form an educated guess about investors’ preferences.

As such, it comes as no surprise that the AUD/USD exchange rate declined in 2022. While the RBA did hike the interest rate, the Fed hiked some more. Even if the RBA moves the cash rate higher by another 50bp on Tuesday, the cash rate will remain below the Fed’s current 1.5% level.

Moreover, the market expects another 75bp rate hike from the Fed in July. Hence, with the interest rate differential forecast to widen, the pressure on the AUD/USD exchange rate should persist.

From a technical perspective, the AUD/USD trades below the pivotal 0.70 level. While below, any bounces will likely be met with more selling.

Other AUD pairs may look interesting to traders from an interest rate differential perspective. For instance, the EUR/AUD pair may give up some of its recent strength as the differential between the interest rates in Australia and the Euro area widens too.

All in all, the RBA was the first central bank to announce its monetary policy decision in July. Before acting on the RBA’s announcements, traders should interpret any decision in light of what the other, more important, central banks will do in July. More precisely, in July, it matters more what the Fed and the European Central Bank will do then what the RBA does on Tuesday.