Last week we offered our opinion of the Australian dollar in an article, Aussie Dollar Rolling Over from Highs - Is there More to Go? For a number of reasons we suggested there was some more downside potential. Like currency markets so often do, they give a head fake, first above 1.0630 before reversing direction.
The catalyst for this week's change in the direction of the Australian dollar has been concern about the Chinese economy. As the world's second largest economy, and Australia's biggest trading partner, the impact on the economy is of special importance.
As a consequence of the massive liquidity pumped into the Chinese economy by central planners, that country was able to avoid a recession suffered by the rest of the world. But the availability of such an abundance of funds has come with a price, resulting in a massive real estate bubble, inflation and a significant increase in labor costs.
As the bubble deflates, an army of traders and pundits has assembled to watch and to search for trading opportunities. Will the Chinese successfully negotiate a "soft landing" or will there be economic dislocations that will affect its trading partners?
Observing from the outside in Europe it is hard to foresee a solution. Perhaps some of these issues are being debated in China. For years the Chinese format had been to move 20 to 30 million farmers to the city. As a new source of cheap labor, this enabled the Chinese to sell products to the world. Their currency was fixed to the U.S. dollar, enabling them to remain competitive, thereby building the world's largest currency reserve.
Now, the central planners in China are confronted with many challenges. Labor costs, partially caused by inflation, are now higher than many surrounding countries. Employers in China, to pay employees, must now focus on more value added products, or lose money.
With the larger paychecks, the Chinese are becoming busy consumers. Their purchases of new cars has exceeded the level of sales in the U.S. for several years, and this has helped keep the global oil market firm despite slow economic growth elsewhere. The video game "Angry Birds" is approaching one billion cumulative downloads, shortly, many to cell phones in China.
The Chinese growth, compounded in double digits for years, was a result of exports, private sector growth and aggressive spending on infrastructure by the government. Building cars, high rise buildings, roads and bridges all required steel, and Australia supplied 60% of the iron ore needed to make the steel. As the demand for the ore increased, so did the price.
Going back to July 2002, the price of Chinese imported iron ore spot Tianjin was $12.68 per metric ton. By July of 2006, the cost had increased to $33.45. By July 2009 the price was up to $83.95, and in July 2011 the price had soared to $172.98 per ton.
On Monday, "markets shuddered this week when BHP Billiton (BHP) said Chinese demand for the steel making commodity was flattening." Opinions that Chinese demand is softening was a negative input for equities and the Australian dollar this week. What may be even more important than the volume of ore shipments and the value received by them is the increase in ore supply.
An article in Seeking Alpha by Paulo Santos, "Iron Ore Margins Can't Last," is prescient. He says:
"There is one simple rule in the world of business. If someone has some kind of business selling something fungible that anyone can sell, and that business somehow manages to attain very high margins, a lot of different people will step into the same business, trying to sell the same thing, to the point where margins collapse for every seller.
Iron ore is one such business. There isn't a reason not to produce more iron ore at the moment, it just takes more investment. Sure, the mines take a while to come online, but there's no incredible physical limit against which industry might be bumping (unlike oil). Yet, presently iron ore is producing what can only be termed as massive margins. Take for instance BHP Billiton. Around 50% of BHP's EBIT is coming from iron ore, but more importantly, this iron ore is being sold at an unbelievable 65% EBIT margin, above any other product BHP sells, including crude. The same goes for Rio Tinto (RIO), while 45% of its 2011 revenues came from iron ore, a massive 70% of its EBITDA was also derived from iron ore. Obviously Vale S.A. (VALE) is not much different, with 72.5% of its revenues coming from iron ore."
With increase supplies of ore coming on stream, we wonder if the BHP exec's concern is understated.
Coal demand in the last decade has had a dramatic increase in both price and demand, like iron ore. Australian thermal coal with 12,000 btu per pound FOB Newcastle/Port Kembia in U.S. dollars/per metric ton was 24.90 in July of 2002. By July 2011 the price was 128.67 per MT.
The money flow from metals which has ballooned the value of the Australian dollar has been a mixed blessing. For example take the auto industry. There General Motors (GM) has a joint venture with the government to make Holden cars, sold primarily in the domestic market. The soaring Australian dollar has made imports cheaper, and has forced a layoff at its assembly plant in Adelaide.
Toyota (TM), with a plant in Altona, announced they were laying off 10% of its workforce this past January. There they made cars for export, primarily to the Middle East. The strong Australian dollar has resulted in a further reduction from the 83,000 cars they shipped in 2010.
The list of casualties caused by the strong Australian dollar grows. BlueScope Steel, the country's largest steel producer, closed its export division. Australian wine exports dropped to a 10-year low in 2011.
Despite evidence of a slowing economy, and harm being caused by the highest central bank rate in the developed world, the Reserve Bank maintained that rate at a meeting last month. Today in The Australian, a former RBA board member Solomon Lew had this to say:
"I really believe the Reserve Bank has mishandled the mining boom to the great detriment of the non-mining sector and particularly retail, which is one of the key drivers of economic activity."
"I'd be calling on the Reserve Bank to cut interest rates by 50 to 75 basis points at the next meeting. I think the Australian economy's in trouble."
Perhaps the mining boom is not over, but it is slowing. Currency specs were amply rewarded, riding the multi-year bull market in the Aussie. Now like generals preparing to fight the last war, currency specs are ready for the next bull move.
As we pointed out yesterday, the open interest in the currency markets has grown, primarily in the Australian dollar because of buying by speculators. From September 2011 until the expiration of the March contract this week, the open interest in the Australian dollar has doubled.
On the third of April we get the next central bank statement on interest rates. Is there any chance spec liquidation takes the Australian dollar back to USD parity by that time? Considering the fundamental news, we suspect there are way too many longs in this market, and a sell off is possible.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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