According to one analyst iron ore prices show "multiple negative short-term indicators" - what does this bode for the Australian dollar's outlook?
The Australia dollar has had a torrid time in May losing 5.92% so far, and falling from a high of 0.7596 to a monthly low of 0.7146.
Against the British pound weakness was just as evident with GBP/AUD rising from 1.9224 to current levels around 2.03.
Investors’ heightened expectations that the Reserve bank of Australia (RBA) will reduce interest rates after a surprise cut in April, lacklustre macroeconomic data, and a correction in most commodities are all contributors to the fall of the Aussie.
Australia’s largest export product is iron ore, the higher the price, the higher the aggregate demand for Australian dollars to purchase them, and therefore the stronger the Aussie gets.
Therefore, the outlook for iron ore prices is incredibly important for the outlook of the Australian dollar.
According to analysts at research firm Liberum, the fall in the price of iron ore, is as a result of reduced demand for the commodity due to a fall in the profitability of steel.
“Iron ore prices are flirting with $50/t again and with good reason. In the past month Chinese steel production has gone from highly profitable to loss making,”
Clearly this has led to a fall in demand for iron which is used to make the steel.
The chart below shows how periods of unprofitability in Chinese steel production trigger falling iron ore prices.
"This is the strongest signal yet that the sharp restocking at the start of this year driven by Chinese stimulus and aggravated by retail speculation may already be unwinding," says a note from Richard Knights at Liberum.
Further evidence may come when we update our Restocking Indicator at the beginning of next month with the latest Chinese Steel PMI data.
Importantly, overall imports into China were down 2% as the imports from countries that host the major producers were down 70mt in April.
Exports from Brazil and Australia are expected to grow into the second half as new projects ramp up, as well as the potential for Samarco to restart.
"Until iron ore prices fall, the rats and mice production will remain and effectively creates a cap on long term prices," says Knights.
Therefore, with the outlook for one of the key fundamental drivers of the Australian dollar's value expected to remain under pressure we would expect the currency to struggle too.
Stevens Leaves Door Open to Further Rate Cuts
Along with the fall in iron ore prices the Aussie has also been hit in recent days by comments from RBA Governor Glen Stevens, who remarked that the Aussie is, “doing what you’d expect it to do,” (it has fallen over 5 cents in May) and that inflation is a little too low - which according to Kathy Lien of BK Asset Management is a sign that, “suggests he is open to the idea of additional easing.”
From a technical perspective, the AUD/USD pair looks like it is reverting to its previous down-trending behaviour, after a corrective phase.
AUD/USD looks like it is resuming its longer-term down-trend (monthly chart)
On the daily chart the pair has just broken below the 200-day moving average (MA) another bearish sign, although ideally we would like to see a break of the current lows for confirmation as it is still possible the MA could pull the exchange rate back up.
The only sign the short-term trend may be fading comes from the slowing MACD, which shows momentum easing at the pair’s last low, which indicates downside impetus is waning.
Nevertheless, this is not enough evidence to suggest a strong corrective phase higher is about to start, so we tick with our bearish outlook, seeing an extension down to 0.7050 as long as the exchange rate confirms by moving below 0.7130.