While global markets and the Australian media continue to celebrate a high Australian dollar, the truth is that the currency is facing weakening fundamentals.
The prime culprit is iron ore, which is dragging down the terms of trade much faster than anyone in authority has predicted.
In fact, our number one commodity export, which many grey beards of Australian economics have nominated as the primary cause of the high dollar, has fallen 20% in the last month and is down almost 40% on last year's highs.
Iron ore by itself represents more than 20% of Australia's terms of trade so the recent falls constitute a 5% hit to the terms of trade. More worrying, however, is that there appears no immediate relief in site for the commodity.
A technical analysis of iron ore shows a head and shoulders topping patterns on both the spot price and the 12 month swap price:
The downside targets implied by these charts are below $US100.
Technical analysis is a tool not a forecast but the fundamentals look weak enough to take this seriously. An excellent report in the AFR this morning shows just how weak, with a series of bearish quotes from analysts:
The managing partner of research firm J Capital in Beijing, Tim Murray, said that while official data indicated steel production was flat, he estimated it fell by as much as 10 per cent over the first 15 days of August.
“This is the first indication of significant cuts,” he said. “There are some seasonal factors at play, but the volume coming off is unusual.”
…But many analysts are doubtful existing stimulus measures will be enough to underpin demand. “The present malaise [in the iron ore market] is likely to continue for the rest of the year,” CLSA commodities analyst Ian Roper said.
…“The property and ship-building sectors are sluggish,” said Qiu Yuecheng, a senior analyst at Xiben New Line, a steel trader. “Purchases of steel in Shanghai fell 15 per cent in July from the previous month.”
Since last year, there has been some offset to declining prices in rising volumes but there is little hope of that continuing in this environment. Chinese steel prices remain weak:
As are other marginal indicators, such as Chinese bulk shipping prices.
Iron ore's twin is coking coal which is also used in the Chinese steel boom (between them they represent almost half of Australia's terms of trade). Coking coal also sold off again last week, down another 3% to $US177 in sympathy with iron ore. It is also 20% down since June. Still, according to ANZ, contract negotiations for the September quarter have gone better, yielding $US220 per tonne:
Wesfarmer’s 2011-12 financial year results showed coal production increased 23% to 12.4 million tonnes, driven by the successful expansion of coking coal output from Curragh.
The company also announced it had mostly concluded September contract negotiations for coking coal, securing a 4% average increase in prices to USD220/t, which is about 27% higher than the current spot FOB prices (although other major producers struck at USD225/t). This suggests that coking coal prices are expected to improve in the coming quarter.
Recently, the RBA claimed that, after the last few years of shifts to shorter term contract pricing, roughly half of iron ore volumes are now sold in the spot market. Similar changes in contract pricing have occurred in coal markets.
Putting all of this together, we can say that the bulk commodities alone have dealt a blow to the terms of trade (ToT) in the upper single digits in the couple of months with further damage done to real export revenues by the recent bubble in the dollar. This is coming on top of a similar fall in the second half of last year and is a much faster retracement than the 6% fall in the terms of trade forecast in the Budget for all of the 2012/13 year.
Unless imports also reverse (which is very unlikely) Australia's trade and current account deficits will blow out throughout the second half. Gross national income has fallen for consecutive quarters and will retrench further.
Cancellations of iron ore and coal capex projects will accelerate and by the time we get to the MYEFO in November the government will be looking for a big new round of spending cuts if it wants to deliver its projected surplus. Unemployment is going to slowly rise.
Calls made last week that we’ve seen the bottom of this rate cycle are premature, to say the least. The dollar is a bubble.
David Llewellyn-Smith is the editor of the Macro Investor newsletter and MacroBusiness. This is an excerpt from a longer article available at MacroBusiness.