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Summary

  • The Bureau of Resources and Energy Economics has conceded to the strength in the Australian dollar and raised its forecasts.
  • The increased forecast has transformed the Australian dollar from supportive of growth to a major risk factor.
  • A key wildcard is whether the Australian dollar will remain decoupled from the price of iron ore or whether it serves as a leading indicator of iron ore prices.

Australia's Bureau of Resources and Energy Economics (BREE) recently released its Resources and Energy quarterly for the June, 2014 quarter containing a notably more cautious tone toward the Australian dollar (NYSEARCA:FXA) and its interaction with commodity prices (particularly iron ore, Australia's largest export). Specifically, the stubbornly strong Australian dollar has forced the BREE to hike its forecast of the currency's exchange rate in subsequent years and to insert the exchange rate as a specific risk factor to its forecasts on export economics.

For context, here is a key forecast statement from the March, 2014 report:

"Since depreciating in the second half of 2013, the Australian dollar-US dollar exchange rate has remained relatively stable through the first quarter of 2014 and traded at around 0.89 USD/AUD for most of the quarter. Through the remainder of 2014 the exchange rate is forecast decline in response to further tapering of the US' QE3 bond purchases, lower commodity prices (and subsequently declining terms of trade) and more bearish sentiment over economic growth in China."

Throughout the March report, the BREE presumed that a lower exchange rate would support exports across Australia's commodities. Fast-forward three months and the BREE has gone from a 2014-2015 forecast of 0.86 for the Australian dollar versus the U.S. dollar to 0.90 for this period. The catalysts for a lower currency have all disappointed so far. From the June report:

"The Australian dollar remains at elevated levels despite the latest decline in commodity prices. The effect of the deterioration in the terms of trade has been offset by the effect of the expansionary monetary policies of several international central banks. The growth in global liquidity has translated into growing demand for the Australian dollar which is increasing in popularity as a 'safe' currency due to the relative strength of the Australian economy. The exchange rate has averaged around 0.92 in 2013-14 and is forecast to moderate to around 0.90 US dollars per Australian dollar in 2014-15. The effect of monetary policies in key economies is a key risk to this forecast and may result in a higher value for the Australian dollar."

As the world's major central banks have maintained extremely accommodative monetary policy, and looser in the eurozone, the Australian dollar has gained attractiveness as a carry trade currency, safe relative to many of the alternatives.

Perhaps most perplexing for the BREE (and me) is that the Australian dollar has fallen alongside iron ore year-to-date. The chart below juxtaposes the September futures contract (Iron Ore 62% Fe CFR September 2014) {the black line and right vertical axis} with the spot exchange rate of the Australian dollar versus the U.S. dollar [the green line and left vertical axis] over the past year. For most of this time period, the Australian dollar tended to lead iron ore prices by about a month. However, the last (sharp) leg down in the price of iron ore has been accompanied by a stabilization in the exchange rate.

The Australian dollar has appeared oblivious to the plunge in iron ore in recent months

Source: barchart

Perhaps the sharp bounce in iron ore in recent days is the beginning of a very lagged stabilization. Time will soon tell. The BREE is certainly projecting a stabilization in the spot price of iron ore. (FOB = free on board).

A relatively benign projection of the price of iron ore

Source: BREE

The drop in iron ore has not prevented Australia from realizing revenue gains from its exports. Exporters have been able to make up for price with a ramp in volume. Australia is expected to export 680 metric tonnes in 2014, an increase of 17% from 2013. Another 12% increase is forecast for 2015. I am not clear, however, on the destination for this extra ramp.

The BREE's expectations for imports and exports among the major players shows a major surplus. China is by far the dominant player, and its increase of 49Mt from 2013 to 2014 is doubled by Australia's 99Mt ramp. China's 58Mt increase from 2014 to 2015 is more than matched by Australia's 84Mt ramp. If this is the case, the supply surge that is currently helping to depress the price of iron ore should get much worse and not more or less stabilize as expected. The BREE describes this dynamic as capping price gains: "While the iron ore price is expected to rebound later in 2014 as port stock levels in China ease and steel demand picks up again, the abundance of supply that has come online will limit the prospects of iron ore prices rebounding to the high levels of 2013." Moreover:

"Iron ore producers in China have recently reduced their operating costs; however at current prices a large proportion of China's domestic production is still assessed as loss-making. If the same economic reforms in China that have pushed unprofitable steel mills to close are also applied to China's iron ore miners, it is likely that a number will close before the end of 2014. This loss in market supply is unlikely to fully offset the substantial increase in supply from Australia in 2014, but should provide some price support later in the year. In 2014, the iron ore spot price is forecast to average US$105 a tonne, 16 per cent lower than 2013.

In 2015 iron ore prices are forecast to decrease a further 7.6 per cent and average US$97 a tonne. Although steel production in China is forecast to increase in 2015, increasing competition among iron ore exporters to sell their additional production is expected to intensify and push prices lower."

Where is Australia's extra production going?

Source: BREE

This chart makes me wonder about Rio Tinto's (NYSE:RIO) recent claim that China will be ready to absorb Australia's surging production of iron ore.

Overall, iron ore is helping to maintain a relatively strong forecast for GDP growth in Australia. However, the stubbornly strong Australian dollar is cited as a major risk factor. Instead of the story from the March report of a currency supporting future growth, the Australian dollar has now become a risk factor for growth. (emphasis mine):

"The economic indicators for the Australian economy for the first half of 2014 are encouraging and give some optimism that the financial year 2013-14 will be the second year of above-trend growth for Australia since the GFC. GDP growth is forecast to increase to 3.1 per cent in 2013-14, up from 2.6 per cent in 2012-13 (see Table 2). However, maintaining this growth rate in 2014-15 may prove challenging as the Australian economy still faces several risks in the short term including the high value of the Australian dollar, a looming drop in capital investment that will be driven mainly, but not exclusively, by the construction of large resources projects winding up, and addressing the cost-productivity imbalance that has made Australia a high cost country to do business relative to the rest of the world. As a result of these economic challenges, Australia's GDP growth rate is forecast to moderate to around 2.5 per cent in 2014-15."

Next up should be the Reserve Bank of Australia (RBA) using the language of the BREE to put a slightly brighter spotlight on the surprising strength in the Australian dollar. Unfortunately for the Australian central bank, it may still only have rhetoric and jawboning in its arsenal since the growth (and inflation) outlook does not warrant any further rate reductions from today's historically low levels. In the meantime, I have temporarily conceded the stubborn strength by trading around my core short of the Australian dollar versus the U.S. dollar. My two favorite longs for the Australian dollar are against the euro and the Japanese yen (mainly on fades).

Be careful out there!

Source: A Stubbornly Strong Australian Dollar Introduces A Risk Factor Into Economic Forecasts