By Cecile Lefort
SYDNEY, May 6 (Reuters) - The Australian dollar skidded 1 percent on Friday after the central bank slashed its inflation forecasts and markets rushed to price in not one, but two more rate cuts this year.
The Australian dollar AUD=D4 sank over half a U.S. cent to break under 74 cents for the first time in two months. The loss of major support at $0.7386 would likely see a test of $0.7336, the 50 percent retracement of the January-April move.
It has tumbled more than two cents this week and looked on track for its second largest weekly fall in 2016. Still, the Aussie is 1.5 percent higher so far this year, suggesting there was room to drop further.
The Aussie also hit two-month lows against the yen and euro.
The slide came after the Reserve Bank of Australia (RBA) surprised with deeper cuts than anticipated to its inflation outlook. It now sees underlying inflation at just 1 to 2 percent for 2016, from a previous forecast of 2 to 3 percent. RBA's statement is extremely dovish," said George Tharenou, an economist at UBS.
"We reiterate our view the RBA is likely to cut the cash rate another 25 basis points to a record low of 1.50 percent, probably at its August meeting, but there is now risk of further easing beyond this."
interbank futures 0#YIB: rallied sharply, implying around a 75 percent probability of another easing by August and a not immaterial chance of a further move to 1.25 percent.
On Tuesday, the RBA cut its cash rate by 25 basis points to an all-time low of 1.75 percent, citing surprisingly low inflation readings for the first quarter.
Australian government bond futures exploded on Friday, with the three-year bond contract YTTc1 touching a record of 98.450. It was last up 12 ticks to 98.440.
The 10-year contract YTCc1 rose 11 ticks to 97.7200, while the 20-year contract YXXc1 added 6.5 ticks to 97.0750.
Meanwhile, the premium between Australian AU2YT=RR and U.S. US2YT=RR two-year cash bonds dropped to its lowest in a decade at 86 basis points. Local two-year yields have dived 53 basis points in just eight session to reach an all-time low of 1.57 percent.
A side casualty was the New Zealand dollar NZD=D4 which fell to $0.6851, from $0.6884 early and away from recent 10-month highs. Key support was found at $0.6808.
The kiwi has dropped 1.7 percent this week, in part due to falling dairy prices and growing expectations of a rate cut in June by the Reserve Bank of New Zealand (RBNZ).
Overnight index swaps imply an 80 percent chance of an interest rate cut to 2 percent on June 9, from 67 percent before the RBA eased.
Supporting the case for a move was a rise in the kiwi against the Aussie dollar AUDNZD=R as Australia is New Zealand's second largest trade partner after China. The Aussie is down nearly 1 percent against its kiwi counterpart this week.
New Zealand government bonds 0#NZTSY= rose, sending yields as much as 9 basis points lower on the long-end. (Editing by Richard Borsuk)