Australian Dollar Can't Diverge For Long From Falling Iron Ore Prices

by: Ron McWilliams


Australia's economy is transitioning from investment in commodity infrastructure to production.

Considerable investment indicates that considerable production capacity will be the result and will require increasing exports.

Q1 economic data suggested that Australia is successfully transitioning, which lifted Australia's currency.

Money inflows to Australian bonds is also lifting the currency.

But, major declines in iron ore pricing and building stock piles threaten economic performance and successful transition.

Since the latter part of January, the Australian dollar (NYSEARCA:AUD) has advanced some 8.2%, going from .8687 to a recent value of .9401. Currently, AUD values hover around resistance, but are unable to penetrate above. Similarly, the AUD is resilient against decline. Though the currency has been considered a risk-oriented asset due to its link with volatile commodity prices, the Sydney Morning Herald recently reported that it's behaving like a "safe haven" asset, given its strength despite falling iron ore prices and softening demand in China.

Still, the AUD's risk-orientation can't be discounted. Cause for measured concern is that Australia is undergoing a considerable economic transition by moving from intensive investment in developing mining infrastructure to the production phase of that investment. This also creates transformation in Australia's labor market.

Because so much of Australia's economy has been based on developing mining capacity, success of their transition hinges on their ability to translate production into exports. Also, they must remain competitive against inevitable negative commodity pricing trends. Because the Australian economy is so invested in commodity production, especially iron ore, it appears that the AUD will ultimately not be able to escape the gravity of declining iron ore prices.

Positive Q1 economic data and cash flowing into bonds have strengthened the Australian dollar

Trade in the AUD has been driven by very encouraging economic signs, which could ultimately betray a successful transition. For instance, on March 6, 2014, the AUD climbed 94 pips when the Australian Bureau of Statistics (ABS) revealed three months of trade balance surplus starting in November and continuing into January. This trade report for January was released on March 5, prior to the opening of the U.S. markets. Encouraging for this report is a trade surplus of $1.1B (revised) for January, with exports increasing 20% year-over-year (y/y), while imports increased only 7.2% y/y. Significant for this report is since January 2012, Australia had been in a trade deficit.

Similarly, another gap-up for AUD occurred on May 6, with a jump of 133 pips. This time, ABS reported a trade surplus of $731M for March, after having reported a surplus for February of $1.26B. Result was 5 months of trade surplus, after nearly 2 years of deficit. By June 5, however, trade balance data showed a deficit of $122M for April. Still, the AUD advanced 60 pips on the European Central Bank's announcement of a negative .01 interest rate on their deposits.

Disturbing about Australia's improved trade balance is that when surpluses were decreasing from January/February highs into April's deficit number (reported June 5), exports were actually becoming negative month-over-month. Where exports reached a y/y advance of 20% in January, February showed a y/y advance of 17%, March declined to 12.9% and April down to 11.4%. The next report is expected on July 1.

Nonetheless, this data created cash flows into Australia by those seeking yield. Namely, global money is chasing Australia's government bonds that enjoy AAA ratings and higher than peer group yields. For instance, Australia's 10-year bond yields in the area of 3.4% versus U.S. treasuries at 2.6% and German bunds at 1.4%. Consequently, the "Mrs. Watanabe" scenario is a reality. Where Japan is moving out of eurozone assets, the yen is moving into Australian bonds. With such cash inflow into Australia's fixed government income, Morgan Stanley, Westpac Bank and Commonwealth Bank of Australia forecast a return of the AUD to parity with the U.S. dollar by the end of 2014.

For the Australian dollar to remain at its current levels, Australia will have to export ever-increasing iron ore production

Australia's Bureau of Resources and Energy Economics (BREE) put Australia's state of transition into perspective in their May 28 sector update. According to BREE, investment in resources and energy went from 20% of total private sector capital to 60%. This level of investment, however, is looking to decline. BREE's Deputy Executive Director, Wayne Calder said, "While the investment cycle has peaked, Australia is now moving into a period of significant increases in the production of natural resources and energy commodities." Mr. Calder noted that "In the past year alone there have been large increases in production capacity including 215 million tonnes of iron ore, 43 million tonnes of coal and more than 1100 petajoules of gas."

Commodity capacity doesn't stop with projects completed just last year. BREE pointed out that in the last six months, 21 projects were completed for a total value of $25.6B. This helps to account for the considerable increases in production capacity. Further large increases in production capacity can be expected, with BREE reporting that $229B in projects entered the "committed" phase. This means $229B in projects should progress to the completion phase and then generate production.

BREE provided a separate report on May 15, which addressed the issue of demand. While China grew less than at potential early in 2014, BREE noted that China's steel production was a record 201 million tons (MT) in Q1, up 6.8% quarter-over-quarter (q/q) and up 4.9% y/y. Supplying China's total iron ore imports of 221 MT in Q1 were Australia's exports to China of 118 MT, which represented a q/q increase of 4.7%.

In terms of global supply, Australia estimates that its iron ore exports for fiscal year 2013/2014, which ends on June 30, will be 631 MT, downgraded from BREE's reported March estimate of 687 MT. China is the largest buyer of Australian iron, and imported 820 MT of iron ore in 2013 and expects 872 MT in 2014, according to BREE.

Declining iron ore prices are defeating expectations, but not deflating the Australian dollar... yet

Despite Australia's growing production capacity and what appears to be China's sustaining demand, iron ore prices are down 34% year-to-date. June 17 saw spot prices for iron ore at the China port of Tianjin at just $US89 per ton, the lowest since early 2012, when Australia developed trade deficits. Iron ore stock piles in China are estimated to have climbed by 31% this year.

Average iron ore price in 2013 was $US126 per ton and forecasts for average price in 2014 are of $US110 per ton, according to BREE. With prices being much lower than expected, government budget expectations are also changing. Analysts estimated in March, when iron ore had fallen only 12% to $US104 per ton, that Australia's tax revenue would fall by $4B. The state of West Australia was expecting a budget surplus of $175M with $111 iron ore. Worry now is if iron ore stays at $89, the state could see a budget deficit of $1B.

Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP), two of Australia's largest iron ore producers and tax payers, are estimated to have a break-even price on iron ore of $43 and $45 per ton respectively. Despite this, they estimate that for every dollar decline in iron ore price, they lose about $120M in profit.

Hope for iron ore prices increasing is that higher-cost Chinese producers will be pushed out of the market at current pricing. BREE estimates that $100 per ton iron ore pricing sufficiently pressures the higher-cost producers to exit the market. However, for real price support, especially given increasing supply, China's fiscal stimulus will need to generate demand and reduce the growing iron ore stock piles at their ports.

If iron ore dynamics remain as they are, the economic indicators that appear to have been driving the AUD will deteriorate. Certainly, the present fundamentals can't support the AUD at its current levels.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.