Australian Dollar Left Looking Cheap by Iron Ore's Meteoric Rise

- Iron ore prices hit new record
- Offers strong support to AUD
- GBP/AUD could be above 'fair value'

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A surge in iron ore prices has analysts at one Australian lender saying the fair-value of the Australian Dollar has risen to above the levels the currency currently finds itself at.

"The FX market appears to be undervaluing the impact of the rapid rise in iron ore prices to all but record levels," says Sean Callow, Senior Currency Strategist at Westpac in Sydney.

The findings offer support to those currency market participants who are looking for a rise in the Australian Dollar over coming days and weeks.

Iron ore prices surged to a record-high of $US193.85/t (62% Fe, CFR China) yesterday, analysts at Commonwealth Bank of Australia (CBA) say the previous peak was $US193/t recorded on 15 February 2011, but in real terms, spot iron ore prices are about 19% below the previous peak.

Above: Daily iron ore price chart from IG.

The rise in iron ore prices comes amidst ongoing solid demand from the Chinese market.

"Iron ore prices rose on restocking demand before the Labour Day holiday period (May 1-5). Prices also increased on elevated steel margins in China. Steel margins are currently tracking at the highest level since 2018 as China's steel demand continues to impress," says Vivek Dhar, Mining and Energy Commodities Analyst at CBA.

The Australian Dollar tends to benefit when iron ore prices rise, owing to Australia's position as the world's premier export of the raw material.

Rising iron ore prices and strong output from Australian mines have helped contribute to Australia's growing trade surplus through to the end of 2020 and early 2021, which means the country earns more in exports than it pays out for imports.

The dynamic offers a fundamental source of support for the Aussie Dollar.

Westpac say the rise in value of the country's premier foreign exchange earner leaves their short-term fair-value models showing the Australian Dollar to be undervalued at present.

Above: AUD/USD fair-value model, image courtesy of Westpac. 

The midpoint of their fair value model has risen to an 8-week high at 0.8050 for AUD/USD, meaning that the Aussie is now seen as cheap below the 0.7750 level.

Assuming the GBP/USD exchange rate remains constant at the current level of 1.3876, an AUD/USD fair-value rate at 0.8050 implies a Pound-to-Australian Dollar exchange rate (GBP/AUD) of 1.6894.

GBP/AUD is presently quoted at 1.7930.

But a rise in AUD/USD would imply USD weakness, therefore Pound Sterling Live would assume the fair-value for GBP/AUD in Westpac's models is higher.

Regardless, the point Callow stresses to clients in a note out on April 28 is the Australian Dollar is undervalued relative to where the iron ore price is.

"There could be a number of reasons for this undervaluation. The explosion in Covid cases in India; China/ Taiwan incursions; Russian/ Ukraine tensions; US tax policy risks; the potential fate of Biden’s infrastructure plan and risks of a rising US$ through Q2 and into Q3 could all be playing a role," he says.

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Whatever the driver, Callow and the Westpac team tend to see the commodity story as well supported by positive demand and negative supply shocks.

Last week Westpac strategists issued a strong buy recommendation for the A$ below 0.7700.

Can the rise in iron ore prices continue?

CBA's Dhar says he sees upside risks to existing forecasts for the commodity.

He explains in a note out on April 28 that China’s steel demand has surged due to stimulus measures deployed in 2020.

Authorities allocated RMB3.75trillion in special local government bonds last year –a 74% increase from 2019.

"These bonds are generally used to fund infrastructure projects," says Dhar.

According to CBA analysis, China’s steel demand and steel mill margins will likely dictate the direction of iron ore prices in 2021.

With policymakers allocating RMB3.65 trillion in special local government bonds this year, Dhar says China’s steel demand will likely remain strong, albeit slightly slower than 2020.

"We see upside risks to our forecast for iron ore prices to average $US110/t in Q4 2021," says Dhar.