Australia dlr dumped on weak jobs data, rate cut risk returns

* Aussie hit by job losses, down across the board

* Markets swing back to pricing risk of rate cut

* Kiwi falls in sympathy, but leaps on Aussie

By Cecile Lefort and Naomi Tajitsu

SYDNEY/WELLINGTON, Jan 16 (Reuters) - The Australian dollar sank to a 3-1/2-year low on Thursday after a soft employment report cast doubt on market perception the Reserve Bank of Australia was done cutting rates, dragging the New Zealand dollar lower in its wake.

The Aussie dollar dived a full cent to $0.8797 AUD=D4 , its lowest since August 2010, while interbank futures and bank bill futures rose sharply. It was last at $0.8808 and technicals looked bearish following the loss of major support at $0.8820.

The next big support level is at $0.8770, a trough from August 2010. Losses were across the board, with the Aussie falling about 1 percent against the euro, yen, pound, kiwi and Swiss franc.

Triggering the selling was data showing employers shed jobs at the fastest pace in nine months in December, with full-time positions posting their biggest drop since mid-2011.

While unemployment did stay at 5.8 percent for a third straight month, it was only because the participation rate dropped to its lowest since April 2006. News Search ID:nL3N0JR09S

The poor outcome seemed to revive expectations of a cut in interest rates from a current record low of 2.5 percent.

Interbank futures 0#YIB: show a one-in-two chance of a easing by July, compared to just one-in-four before the data. Yields on three-year government debt AU3YT=RR pulled back 9 basis points to 2.90 percent, well away from last year's peak of 3.21 percent.

"Overall, data shows the labour market is weak and the market had been wrong to rule out an easing," said Matthew Johnson, a rate strategist at UBS. "The market should have at least another rate cut fully priced-in."

Johnson still suspects the Reserve Bank of Australia will attempt to stay on hold, but sees the possibility of one or even two rate cuts starting in May.

The yield curve duly widened with the premium offered by Australian 10-year debt AU10YT=RR over three-year widening to 130 basis points, from 123 basis points last week.

Swap rates CSSY swung back to pricing in an easing on a 12-month horizon, albeit only of 4 basis points.

They were implying 6 basis points of rate hikes before the data, largely because of a lower Aussie dollar and fairly stable economic outlook from China, Australia's top export market.

NZ RATES HEADING OTHER WAY

Across the Tasman sea, the New Zealand dollar NZD=D4 slipped 0.3 percent to $0.8310, further retreating from a near three-month high of $0.8433 hit earlier this week.

The kiwi jumped against the Aussie to around NZ$1.0576

AUDNZD=R , its highest since late 2005. Against a basket of currencies the kiwi was hovering near an eight-month high of 79.24 hit on Wednesday.

While the Australian economy struggles, New Zealand's has been growing strongly and expectations are high it will be the first developed nation to raise rates this cycle.

The Reserve Bank of New Zealand holds its first meeting of the year at the end of this month and swap rates imply a one-in-three chance CSSY of a hike in the 2.5 percent cash rate.

New Zealand inflation data are due next week and another tame number could nudge the central bank into holding off on a hike until its March meeting.

While many in the market see more room for the kiwi to rise, its inability to hold gains above $0.8420, roughly the level of previous highs hit in November, has stymied its attempts to push up towards the mid-$0.8500 region.

As resistance builds around $0.8420, external factors, including more signs that the U.S. economy is improving, could take the wind out of the kiwi in the near term.

New Zealand government bonds 0#NZTSY= rallied, pushing yields down as much as 4 basis points at the long end of the curve.

Australian government bond futures jumped with the three-year bond contract YTTc1 up 11 ticks at 97.080. The 10-year contract gained 6 ticks to 95.880, leading to a bullish steepening of the yield curve.

(Editing by Eric Meijer)

((Cecile.Lefort@thomsonreuters.com)(+61 2 9373-1234)(Reuters Messaging: cecile.lefort.thomsonreuters@reuters.net))

Keywords: MARKETS AUSTRALIA/FOREX