SYDNEY: The Australian dollar jumped on Tuesday after the country’s central bank raised interest rates and warned that even further tightening might be needed, stunning markets that had wagered heavily on an extended pause.

The Aussie climbed 1.0% to $0.6698 after the Reserve Bank of Australia (RBA) lifted rates by 25 basis points to 3.85%, bringing its tightening in the past year to an eye-watering 375 basis points.

Markets had been priced for no change, given core inflation had eased a little more than expected and the full pain of the RBA’s past tightening had not yet been felt. RBA Governor Philip Lowe said that even more tightening might be required to ensure that inflation returns to target in a “reasonable timeframe.”

Bond investors took the news badly and three-year futures dived 23 ticks to 96.780, the sharpest daily drop since mid-2012. Futures slid as the market priced in the new 3.85% rate and implied around a 60% chance rates could reach 4.10% by August.

“Softer core inflation gave the Bank some breathing space, particularly on concerns around mortgage rates, but the focus in this instance is high services prices and rising labour costs,” said Dwyfor Evans, Head of APAC macro strategy at State Street Global Markets.

“This is a decision that will support the AUD, particularly against currencies where the hiking cycle has come to an end.”

Yields on 10-year bonds climbed to 3.495%, from an early low of 3.377%, having bounced between 3.16% and 3.95% in the past few months as market sentiment on rates swung from hawkish to dovish.

Australia dollar falters, bonds rally after core inflation surprises to downside

The New Zealand dollar lagged at $0.6188, as the Aussie dollar rose 0.7% to NZ$1.0944.

The Aussie also surged 1.1% on the yen to 92.20 yen. Markets still think the doggedly hawkish Reserve Bank of New Zealand (RBNZ) will raise rates a quarter point to 5.5% at its policy meeting later this month.