Terms of trade shock developing

By David Llewellyn-Smith

I know that at the moment it’s much more fashionable to celebrate the bubble in the Australian dollar than it is to point to weakening fundamentals, but the fact is our terms of trade are falling fast. The prime culprit remains iron ore, which late last week broke down again:

And the charts:

That’s a 20% fall since June and by itself constitutes a 5% hit to the terms of trade. My original downside target for this move was $110 for spot but that’s now looking conservative. Suddenly the head and shoulders topping patterns on spot and 12 month swaps are looking persuasive. Indeed, the downside targets suggested are a long way below. On that basis, I asked The Prince to do a technical analysis:

1. Low of $60 per tonne is the extreme target for any crash, being the level reached in March 2009 – not likely unless the world is ending.

2. Support is just below $120, where the June 2010 and Sept 2011 corrections occurred and has been tentatively broken. This could be a bear trap. For the trap to shut, the price needs to come back above that level, and then for the market to resume a sideways trend that breaks the red downtrend line.

3. A new rally must break the 200 day moving average – at 138 per tonne currently. Very low probability given this market condition.

4. There’s daylight below if price does not get back above support in the next month or so. The interim target is $100 (a psychological level), and the actual target is around $75 a tonne.

5. Here are the Fibonacci retracements:

• 61.8% the head in the recent head and shoulders
• 50% is the neckline of that head and shoulders
• 38.2% level is the almost $120 support line that was broken
• 23.6% is $100 level (look to the left where it tested, failed and then retested and broke through eventualy in the 2nd half of 2009)
• 0% at $73-75 is the target.

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.”

…A report this month by leading US fixed interest fund manager Pimco said Chinese steel production had reached a near-term peak.

“The Chinese steel industry today shows many signs of serious economic difficulties brought about by the unprecedented size and speed of industry expansion,” the report says.

…Mr Murray said while many projects approved by the government in April were beginning to come through, they would not have a significant impact on steel demand.

And Chinese steel prices remain weak:

As do Chinese bulk shipping prices, though coal is much improved:

On cue, the thermal coal price has bounced a little and is now down around 15% or more since May:

But coking coal sold off again last week, down another 3% to $177 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 $22o per tonne:

Wesfarmer’s FY12 results showed coal production increased 23% to 12.4mt, 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.

The recent RBA SoMP 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 (see the below document). Similar changes in contract pricing have occurred in coal markets though I do not know what the ratios are with spot versus contract, nor for that matter, how such a large discrepancy can exist between the forthcoming three month coking coal contract and spot prices. Any input on this subject from readers is welcome.

Putting all of these together, we can say that the bulks alone have dealt a blow to the terms of trade (ToT) in the upper single digits in the past three 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 in the ToT than anyone in authority has forecast. The Budget is relying on a 6% fall in the ToT for all of the 2012/13 year.

Unless imports also reverse, the 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.

Rba-

ANZ Commodity Daily 685 170812 (1)