By Wayne Cole
SYDNEY, Nov 27 (Reuters) - The Australian dollar looked vulnerable on Wednesday as investors rushed to price in an extra policy easing for next year after the country's central bank signalled there was more room to cut rates than previously thought.
The Aussie traded a shade softer at $0.6786 AUD=D3 , having briefly been as low as $0.6768 overnight. It again lagged the New Zealand dollar which held firm at $0.6425 NZD=D3 .
The market had assumed the effective floor for rates was 0.5%, but Reserve Bank of Australia (RBA) Governor Philip Lowe indicated they could fall to 0.25% before it would consider unconventional steps such as buying government bonds. 0#YIB: reacted by rapidly pricing in the risk of two further rate cuts from the current 0.75%, as opposed to just one. An easing to 0.5% was now fully priced by May next year, while a drop to 0.25% was seen as a 30% chance by November.
Lowe, however, showed little appetite for a near-term move so the probability of a cut at its next policy meeting on Dec. 3 was scaled back to only 12%.
While Lowe argued that quantitative easing (QE) was a distant prospect, he did confirm that any action would involve the bank buying government bonds rather than other assets.
All of which helped three-year bond futures YTTc1 climb 5 ticks to a six-week peak at 99.320, implying a yield of 0.68%.
Yields on the cash 10-year bond AU10YT=RR dropped to 1.05% and further away from the November top of 1.34%.
"We assumed 10-year bonds would end 2020 at 0.6% alongside a 0.5% policy rate and QE," said Prashant Newnaha, a senior Asia-Pacific rates strategist at TD Securities.
"Lowe's suggestion of a 0.25% effective lower bound coupled with QE means 10-year yields could reach as low as 0.4%. We also see the risk of the 3s-10s curve flattening a little more through our 2020 year-end forecast of 20 basis points."
Markets are not nearly so bullish on New Zealand, where a single quarter-point rate cut to 0.75% is priced as, at most, a 70% probability by late next year RBNZWATCH .
As a result, Aussie 10-year yields were now 28 basis points below NZ yields NZ10YT=RR , compared to 11 basis points early this month.
The Reserve Bank of New Zealand (RBNZ) released its semi-annual review of the financial system on Wednesday but gave no update on monetary policy.
The central bank said it was ramping up its scrutiny of banks and insurers ahead of its highly anticipated decision on raising bank capital requirements. (Editing by Shri Navaratnam)