Is Australia an iron ore hedge fund?

MB alumnus turned Business Insider scribbler Greg McKenna made an interesting observation yesterday:

ANZ-iron-ore-v-bond-spreadEven though iron ore is Australia’s largest export, accounting for around 22% of total exports, it still only accounts for 4% of GDP.

That’s why this chart on the correlation between the Australian Government-US Treasury spread and the price of iron ore is so startling.

It shows the impact of market sentiment on asset prices and differentials. It’s also an amazingly strong directional correlation, given the impact of iron ore on the terms of trade.

IG-AUD-Bond-and-iron-oreWhen you tie up the impact of iron ore on the Aussie-US bond spread and the AUDUSD directly as Chris Weston, IG’s Chief Market Strategist Australia, has done in a note to clients today, you get a real sense that traders are punting bonds and the Aussie dollar on the back of the big swings in iron ore.

It’s almost impossible to argue against this theory based on the recent price movements in the markets he’s discussed.

That leaves us with one obvious result — while other factors, like the US dollar, are important, it looks like traders are treating the Aussie dollar as a giant bet on iron ore prices.

The piece offers an implied critique of what is a largely accurate observation about markets, which are treating Australia as iron ore hedge fund (although that broke down recently when the RBA stopped cutting).

But markets are exactly right. The inflation of steel commodities – iron ore and coal – accounted for an astonishing percentage of the mining boom. In terms of income, the steel commodities were pretty much all of it:

ScreenHunter_7225 Apr. 27 10.52

Thus there’s not much point in using GDP as a guide to how small iron ore is relative to the economy when it is the income that matters. Especially so when one factors in that the second part of the Australian economic process is to leverage that income via offshore borrowing to support services sector activity. Usually that is banks and mortgages but more recently that hasn’t been enough to support GDP and the Government has been doing the leveraging as well.

Thus, when viewed in its entirety it is true that the Australian economy is more than just an iron ore hedge fund. Rather it is an iron ore structured product in which the underlying income producing collateral pool is leveraged up in a mezzanine tranche of Government borrowing, which is leveraged up in an secondary tranche of mortgages and house prices inflation. If we add that the iron ore income is itself based upon huge and unsustainable Chinese leverage then the entire unwieldy structure of leverage upon leverage upon leverage resembles a synthetic iron ore collateralised debt obligation (or CDO cubed for short).

And we wonder why markets start selling dollars when the base income shrinks!

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