The Australian Dollar's Iron Ore Headache

Global commodity prices are on the up, but iron ore isn't, and this will continue to weigh on the Australian Dollar.

What matters for the Australian Dollar right now?

Focus appears to be on the soft spots in the Aussie economy, Australia's interest rate yield superiority and what the Reserve Bank of Australia's might or might not do to interest rates in the future. But there is a risk investors take their eyes off iron ore - Australia's largest export.

Statistics from Australia's Department of Foreign Affairs and Trade show that in 2016 iron ores and concentrate exports accounted for 16.3% of Australian exports confirming it to be a significant foreign exchange earner for the country.

Understandably, changes either up or down in the price of the commodity are mirrored by moves in the exchange rate. Therefore, when the price of iron ore increases, the aggregate demand for Aussie Dollars also increases, pushing up the value of the Australian Dollar in the process.

We can see the high correlation on the chart below which shows the Australian vs. US Dollar exchange rate overlaid against the global price of iron ore:

The latest price points on the chart show suggest that at present the price of iron ore is dragging the value of the Australian Dollar lower.

"AUD remains under pressure versus the USD, despite that some commodities are booming again. But Iron ore is not," says FX Strategist Steno Larsen at Nordea Markets.

The chart also suggestion the Australian Dollar is vulnerable to further weakness if it is to fully restablish a close correlation with iron ore. However, the chart does hint that the correlation is never a perfect one, rather both trend in a similar direction, therefore keeping an eye on iron ore prices is important.

Right now, the prospects of a significant shift lower in iron ore prices looks unlikely if we consider the state of the global economy which is firing nicely.

"We believe the Aussie will take a further leg down as the price of Australia’s main commodity export, iron ore, falls... we suspect that a more sustained weakening in construction activity in China will cause the iron ore price to fall from US$63 a tonne to around US$50 a tonne by the end of this year," says Paul Dales, an analyst with Capital Economics in London.

China’s iron ore imports remains relatively robust despite steel cuts; China imported 88.2mt through its ports in October up from 86.3mt in September despite steel cut to steel production capacity in the recent anti-pollution drive.

China is looking to combat smog by limiting output in the most polluting of industries and this is efficiently curbing raw material purchases in October from record-breaking imports in the months prior, as factories continue to clear inventories during ongoing production limits.

Imports across a range of commodities including crude oil, gas, iron ore, coal and copper pulled back from September highs as demand from the world’s largest consumer diminished against environmental protectionism.

"Iron ore usage looks likely to pull back as utilisation rates for blast furnaces have fallen to 71% with major steel providence of Hebei set to limit output by 50%," warns John Meyer at brokers SP Angel.

Stockpiles of iron ore at Chinese ports are meanwhile on the rise, indicating solid supply could weigh on prices going forward. Data from Shanghai Steelhome E-Commerce Co. show stockpiles grew 0.4% to 136.3 million tons in the week ending November 3. This is the fifth weekly advance in six weeks.

"The seasonal environmental constraints enforced by the Ministry of Environmental Protection were enhanced by more advanced closures ahead of the week-long national holiday and the Communist Party Congress, serving only to further weaken demand for raw material imports," says Meyer.

Global miners have been increasing output while cuts to steel output during the Chinese winter could ensure prices remain subdued over coming months.

Meanwhile, output cuts on coal consumption have hit imports hard as domestic sources remain more competitive.

Again this is important for the Australian Dollar as coal is Australia's second-largest export.

"Coal has fallen out of favour as air quality improvements focus on the elimination of 44,000 coal-fired industrial boilers and the replacement of coal-fueled household heating with gas or electricity across millions of residences," says Meyer.

In short, the quest for a cleaner environment could prove to be a major drag on the Australian currency going forward.

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Friday Could Be A Big Day for Aussie

The state of the Australian economy, and decision-making at the RBA do of course also have a role to play in AUD valuation.

With this in mind, we watch the release of the 'quarterly monetary policy report' on Friday, November 7, amidst widespread speculation that ithe data is likely to be disappointing, putting further pressure on the Aussie.

"Unease ahead of Friday’s quarterly monetary policy statement, which sees the RBA releases its latest inflation forecasts, could be one reason why Australia’s currency ceded ground to the entire G10 basket barring the Japanese Yen Tuesday," says our own Pound Sterling Live Reporter James Skinner.

The RBA quarterly report is expected to show lower-than-expected inflation.

Inflation is also a major factor in determining the value of the exchange rate.

Inflation determines the level at which the Australian central bank sets interest rates, which has a knock-on effect on the currency. 

The central bank is the 'bank of banks' in the economy, which means that it safeguards money for highstreet banks and also lends them money, which the high street banks then lend to us. 

The central bank adjusts the base interest rate, which is the rate it charges (and pays) high street banks when they borrow and save with it, at regular meetings.

In Australia, the base rate is currently 1.5% - in the UK 0.5%.

The base rate determines the interest rates highstreet banks then charge us, which is normally higher to include a profit margin.

When inflation rises the central bank puts up interest rates in an effort to lower inflation because higher interest rates discourage borrowing and spending by making it more expensive and encourage saving.

But higher interest rates also have a positive impact on the currency by attracting increased flows of foreign capital, drawn by the promise of higher interest returns.

This increased flow boosts demand for the home currency, thus pushing it up.

This is why the quarterly monetary policy report released on Friday could be damaging for the Aussie; if, that is, it reveals lower inflation or even lower inflation forecasts.

Australian Dollar Hit By Investor Preference for Emerging 'Exotic' Market Currencies

There was a time, not long ago, when the Australian Dollar was the darling of global investors.

This was when interest rates in Australia were 2.0-2.5% but in the rest of the developed world were much lower - at or below 0.5%.

In that climate, the Aussie rose strongly as money gushed into Australia due to the higher interest rates on offer to investors.

Since then, however, three major shifts have happened which have undermined the supremacy of the Australian Dollar.

The first is that interest rates in the US have recovered and are expected to follow suit in the rest of the developed world.

The second major event has been the fall in Australian interest rates closing the gap with the rest of the G10. 

The third is a more recent phenomenon which appears to be investor preference for more exotic currencies which have higher interest rates, despite being second world economies, with all the risk that entails from potential lack of via economic stability to investors.

This point is made by investor service Morningstar, who recommend buying emerging market government bonds for their 'higher yield' which typically earn bondholders between 4.0-6.0% per annum.

The interest offered on a government bond when it is issued is typically the same or slightly above that of the central bank's base interest rate

"We have greater conviction in the investment case for emerging-markets bonds, particularly where those bonds are issued in the currency of the emerging-markets nation, although country and currency selection remain vital. With higher yields on offer and, in many cases, emerging-markets countries having much better debt positions, the reward for risk looks superior to that of most developed-markets countries," say analysts at Morningstar.

To summarise, therefore, a preference for funneling money into emerging markets where interest rates are normally between 4.0 and 6.0% appears to be replacing the old Aussie trade for investors seeking higher returns, and this could be a further bearish factor for the Aussie Dollar.

Get up to 5% more foreign exchange by using a specialist provider by getting closer to the real market rate and avoid the gaping spreads charged by your bank for international payments. Learn more here.