Iron Ore and the Dollar — Joined at the Hip

Australian One Dollar Coins over Black

In case you had any doubts about how the economy works or whose benefit it operates for, now you know…

In a recent research note, the Bank for International Settlements warned that negative interest rates might be bad for…the banks!

As the Financial Times reports (my emphasis):

It was unknown, the BIS said, how borrowers and savers would react or whether the channels through which central banks’ rate moves are usually passed on to the broader economy would “continue to operate as in the past”.

The economists also warned that the policy could have serious consequences for the financial sector. Banks have so far taken the brunt of negative interest rates, and have not passed on most of the cost of the cuts to their customers. “The viability of banks’ business model as financial intermediaries may be brought into question,” the research stated.

Let’s not worry about the damage done to savers over many years of low interest rates and quantitative easing. No, that’s fine. But as soon as this policy’s insanity starts to impact the banks, let’s wring our hands and ask what is to be done?

This analysis lays bare the real reason behind negative interest rates. That is, the policy is designed to weaken currencies just as much (if not more so) than it is about encouraging households and businesses to take on even more debt.

Currency devaluation is a zero-sum game. That is, it’s a policy designed to ‘steal’ demand from other nations. So a weakening euro and yen steals demand and growth from stronger currency blocs like the US and China (remember, China pegs its currency to the dollar).

And it’s hard to see this dynamic changing any time soon. For example, US payrolls data out on Friday reflected a very healthy labour market in the US. February job growth came in at 242,000, with positive revisions for January and December. The unemployment rate remains at a low 4.9%

This means that a Federal Reserve rate rise will still be on the table in the months to come. Which means upward momentum should remain with the US dollar.

What does this mean for the Aussie dollar, then? Since making a new low in January at just over US$0.68, the Aussie has rallied strongly, as you can see in the chart below:

Source: StockCharts

[click to open in new window]

In fact, this chart looks bullish for the Aussie dollar. Following last week’s ‘strong’ economic growth data, the Aussie surged and reached its highest level since July 2015. The moving averages (red and blue lines) look set to cross over, which is also bullish.

The reason behind the Aussie’s strength comes down to the simple fact that our interest rate structure looks good compared to the negative rates on offer in Europe and Japan. And as these two are net savers, Australia seems like a good place to send their excess capital savings.

They are obviously not too concerned that the majority of the capital they send our way goes into the housing market, via the banking sector. I’ll get back to that point in a moment.

But let’s finish with the Aussie dollar first. While the chart looks bullish, I wouldn’t be chasing this rally. As well as benefitting from a healthy interest rate differential, the dollar tends to track the iron ore price. And the iron ore price tends to track the stimulus activities of the Chinese government.

Don’t forget that in January, the Chinese economy produced the largest credit surge EVER, following attempts by China’s rulers to ‘manage’ the slowdown late last year. Debt growth, however useless or unproductive in the longer term, ALWAYS creates a short term demand jump.

As a result, the iron ore price has surged too. It jumped from just under US$40 per tonne in mid-January, to over US$50 per tonne now. The dollar rally is a mirror image of the iron ore rally.

The problem is, the fundamentals for the iron ore market remain horrible. Over the years, short term Chinese stimulus efforts have had a big impact on the iron ore price. But after the stimulus wears off, the price fades.

It’s the same with the Aussie dollar. Back in early 2014, following a big sell-off, the Aussie dollar rallied from around US$0.87 cents to US$0.95 cents. At the time, many thought the Aussie had bottomed and would go on to new highs. It didn’t. It turned down and made new lows instead.

The way I see it, the same thing will happen again. Short term Chinese stimulus attempts will wear off and put pressure on the iron ore price and in turn, the dollar. It’s just a matter of time.

That, once again, leaves Australia’s housing sector as the lone prop for the economy. The market has come under intense scrutiny over the past few weeks. Now, the focus is on the rapidly oversupplied apartment market. From the Financial Review:

The number of apartments due for settlement is ballooning and, despite the soothing words from Lendlease and Mirvac at the half-year results, concern is rising about whether buyers will be able to pay for them.

An estimated 44,784 apartments are due for completion and settlement this calendar year across Sydney, Melbourne and Brisbane, up almost a quarter on last year’s 36,486, according to figures from planning consultancy MacroPlan Dimasi.

Next year they will jump again to 52,920, the figures – based on previous apartment approvals – suggest.

But the surge in settlements – this year alone will see four times as many apartments settle as the 11,145 of 2010 – at a time when banks are tightening credit, brings the prospect that buyers who paid a 10 per cent deposit two years ago and were counting on a 90 per cent loan to meet the remainder now due will have to stump up more. If they can’t, they may have to sell them into a weakening market.’

Strangely, negative rates in other parts of the world are not translating into easier credit in Australia. Bank funding costs are increasing. That tells you the world sees our housing market as increasingly risky.

This issue is crucial for Australia. If foreign creditors turn on us, our economy is toast.

Greg Canavan,

For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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