Credit - Alive and Kicking

"What you gonna do when things go wrong? 

What you gonna do when it all cracks up? 

What you gonna do when the Love burns down? 

What you gonna do when the flames go up? 

Who is gonna come and turn the tide? 

What's it gonna take to make a dream survive? 

Who's got the touch to calm the storm inside? 

Who's gonna save you? 

Alive and Kicking 

Stay until your love is, Alive and Kicking 

Stay until your love is, until your love is, Alive"

- Alive and Kicking - Simple Minds - 1985

Songwriters: Kerr, James / Macneil, Michael Joseph / Burchill, Charles

While enjoying the smoother driving commute to work courtesy of the summer lull, we listened to old classic 1985 "Alive and Kicking", from Scottish rock band Simple Minds, and some of the lyrics did struck a chord with the on-going central banks "kicking the can" game which has been increasing the correlation between asset classes and the levitation process. Therefore, in continuation to our previous use of musical references for our title analogy, we thought this week's title reflects our current interrogations on central banks abilities in dealing with the next burst of the asset bubble they have so aptly created thanks to their numerous and generous liquidity injections from the last couple of years.

In this week's conversation, we would like to focus our attention on the inherent "instability" which has been building up in all asset classes due to rising correlations, the consequences of negative real returns, and how to somewhat side-step negative convexity thanks to CDS. But, first, our usual market overview:

The volatility in the fixed income space has been receding during this on-going summer lull as displayed by the recent evolution of the Merrill Lynch's MOVE index falling from early May from 48 bps  towards the 75 bps level - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

A low volatility regime until May had benefitted the most carry trades such as Emerging Market Bonds as well as high carry Emerging Markets currencies. This was the direct consequence of negative interest rate of return on US Treasuries for the last couple of years due to "financial repression". Following the huge surge in volatility after the conflicting "tapering" signals sent out by the Fed that began in May, Emerging Market currencies should remain volatile and under pressure in the coming months as indicated by Bloomberg's "Chart of the Day" from the 5th of August displaying JP Morgan's Emerging Market Volatility Index:

"The CHART OF THE DAY shows JPMorgan Chase & Co.’s Emerging Market Volatility Index since Fed Chairman Ben S. Bernanke told Congress in May that policy makers may temper bond purchases that helped spur $3.9 trillion in capital flows to developing countries in the past four years. The gauge jumped to a one-year high of 11.8 percent June 21, before falling to 9.5 percent yesterday after the Fed said it will keep stimulus for now. The index’s 35 percent quarterly increase was the most since 2011.
Currencies in Brazil, India, South Africa, Turkey and Chile have fallen at least 7 percent since May 1 as higher Treasury yields lured investors away from emerging markets. Developing countries are paying for the Fed’s mixed signals and ministers from Chile to South Africa share India’s “unhappiness over the developments,” Indian Finance Minister Palaniappan Chidambaram said in an interview with the Times of India published July 31" - source Bloomberg.

A clear illustration of this surge in currency volatility can be seen in the depreciation of commodities linked currencies such as the Australian dollar and the Brazilian Real, which had been perfectly correlated since 2008 until the summer of 2011, which saw the start of some large unwinds from the Japanese levered "Uridashi" funds (also called "Double-Deckers") from their preferred speculative currency namely the Brazilian Real. Created in 2009, these levered Japanese products now account for more than 15 percent of the world’s eighth-largest mutual-fund market and funds tied to the real accounted for 46 percent of double-decker funds - graph source Bloomberg:

The Brazilian Real was one of the top "Double-Deckers" preferred currency play for its previous interesting carry. These funds represented 126 billion USD in asset in 2011:
"As we indicated in October 2011, in our conversation "Misery loves company", the reason behind the large depreciation of the Brazilian Real that specific year was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again."

Following the violent surge of volatility in the fixed income space the recovery in Investment Grade credit indicated by the price action in the most liquid US investment grade ETF LQD and High Yield, as displayed by the lost liquid ETF HYG has been more muted in the US - source Bloomberg:

But as far as credit cash markets are concerned in the European space, European cash spreads are now within 5 bps of tights post the Great Financial Crisis, with the Iboxx Euro Corporate index, being one of the most used benchmark in European Investment Grade mutual funds tighter by 6 bps so far in August as indicated in a recent note by CITI "The Reluctant rally" from the 9th of August:
"In aggregate, the € iBoxx index has now taken back more than 80% of the widening in May and June – in other words, we're just 5bp from the tightest level credit has seen since 2008.
We're big advocates of leaning against the wind in the current range-bound market environment and have been suggesting taking profits at the margin where spreads have tightened the most. But we remain long. Why not be more resolute and go underweight here at these tight valuations? Sure, the European and US macro data is supportive but, after all, there's plenty of uncertainty in store in the autumn: the impact of actual Fed tapering, US debt ceiling discussions, European politics after the German elections, the German constitutional court ruling on the OMT, FTT negotiations, bank repositioning on the back of the latest Basel guidance, periphery politics, Chinese data, Middle East tensions to name a few.
Some of these issues may yet come back to haunt us but, at the moment, we struggle to see the vulnerability in the European cash credit market even at these tight levels." - source CITI

As far as credit markets are concerned, they are no doubt, "Alive and Kicking". And we agree with CITI, as the Simple Minds (like ours) song goes:
"Stay until your love is, until your love is, Alive"
So stay in credit until your love is alive, but get close to the exit as we move towards a heightened risk of a fall during the Fall (Autumn that is...).

It is a similar story for European Government Bonds yields as indicated in the below graph with German 10 year yields staying between the 1.60% / 1.70% level and French yields now around 2.26% flat from last week, with Italian and Spanish yield grinding tighter - source Bloomberg:

Moving on to the subject of rising correlations and the buildup in "instability", we agree with Martin Hutchinson's recent article "Forced Correlations" published in Asia Times:
"In 2009-10, ultra-low interest rates forced up commodity prices themselves, but since then new sources of supply have been forced onto the market, causing a reversal of the commodities bubble. In energy, fracking techniques caused a collapse of natural gas prices in 2011-12, but it's interesting to note that no such collapse has occurred in the oil market, presumably because the new supply sources are insufficient and have been offset by the artificially increased demand for automobiles in China and India especially. 

Interestingly, the rise in gold and silver prices caused by cheap money (if cash has a negative real return then gold and silver are ipso facto a good investment) has been suppressed over the last 18 months by the International Monetary Fund and the world's central banks, seeking to disguise the true effect of their monetary policies, but this effect may be wearing off. 

Finally, negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson

Dollar index versus Gold - graph source Bloomberg:

While recently the dollar has been weakening so far against major currencies with a significant bounce from the Japanese yen and Australian dollar, should "risk-off" materialize during the Autumn, the dollar could significantly benefit yet again from a flight to safety.

The credit markets and equities are no exception to "rising forced correlations" as highlighted by CITI's recent note from the 9th August entitled "Forget the Great Rotation":
"Rotation – isn’t it obvious?
It's not hard to figure out why the 'Great Rotation' has been such a hot topic this year. It seems so intuitive: as yields rise over the next few years in response to a gradual economic recovery, total returns in fixed income will be weighed down, if not outright negative. The asset class that has the most to benefit from growth is equities.
For example, for the past year we have continuously highlighted the asymmetry in risk/reward between equities and credit. As illustrated in Figures 2 and 3, credit and equities have correlated closely over the last few years and almost in a constant ratio. We don't see why that wouldn't work in reverse also.

However, as credit spreads get closer and closer to the lower bound it becomes increasingly difficult for them to continue performing in the historical relationship with equities. The slight gap that appears to be opening up in both charts recently seems to bear that out.
In other words, to our minds there is an obvious long-equities-short-credit relative value trade insofar as credit has all the downside potential of equities, and much less of the upside." - source CITI

For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":
"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 

However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 

Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson

"What you gonna do when things go wrong? 

What you gonna do when it all cracks up? 

What you gonna do when the Love burns down? 

What you gonna do when the flames go up? 

Who is gonna come and turn the tide? 

What's it gonna take to make a dream survive? 

Who's got the touch to calm the storm inside? 

Who's gonna save you?"

- Alive and Kicking - Simple Minds - 1985

But we are not there yet...

Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":
"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.

This is particularly true for callable high yield bonds such as Windstream:
"We can again use Windstream to illustrate this dynamic. Figure 5 shows the duration (OAD) and yield to worst of the WIN 7.5s of 2022 from May 10 to August 7. As the bond sold off from May 10 to June 24 (yields rose), the duration increased as well, due to the negative convexity of the bond.

The increase in duration resulted in larger losses for the bond relative to an equivalent non-callable bond and CDS. In the subsequent rally, duration declined, resulting in a smaller gain relative to a non-callable bond and CDS. The negative convexity of the bond enhanced the downside during the sell-off and limited the upside during the most recent rally. Remarkably, even though nearly three months have passed, duration remains toward the high end of the range. The holder of the bond not only suffered a mark-to-market loss, but now has to contend with a higher duration investment that continues to suffer from negative convexity." source Barclays

The illustration of the downside protection offered by the CDS market as well as the better liquidity provided by the CDS market can indeed mitigate the damages as illustrated by the Total Return performance on a callable High Yield bond suffering from negative convexity versus its CDS - graph source Barclays:

"CDS has outperformed the 2022s by more than 400bp in P&L terms (Figure 8) due to the rate exposure and duration extension of the bond." - source Barclays

Nota bene: Liquidity in the CDS market tends to be greatest at the 5 year point, making the 5 year single name CDS contract a more viable alternative than other CDS maturities.

Conclusion:
With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger...

On a final note, counter-intuitively, rising yields should benefit US companies suffering from ZIRP due to rising  Pension Funding Gaps which have not been alleviated by a rise in the S&P 500.

As a reminder from our conversation "Cloud Nine":
"If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2."

We agree with Bloomberg that rising stock prices have done little to bolster the finances of corporate pension funds this year - graph source Bloomberg:

"Rising stock prices may do relatively little to bolster the finances of corporate pension funds this year, according to Tobias M. Levkovich, Citigroup Inc.’s chief U.S. equity strategist.
As the CHART OF THE DAY shows, the percentage gap between pension assets and obligations for companies in the Standard &Poor’s 500 Index widened last year, when the stock-market gauge increased 13 percent. The S&P 500 rose another 19 percent this year through yesterday.
Assets were 23 percent less than projected payouts at the end of 2012, according to data from S&P Dow Jones Indices that Levkovich presented in an Aug. 2 report. The shortfall was the biggest since at least 1991.
“Overall pension pressures have not eased” even though the S&P 500 has more than doubled since March 2009, when the current bull market began, Levkovich wrote. “The stock market is crucial to the asset side of the pension story.” Managers contributed to the wider funding gap with their reluctance to put more money into equities, the New York-based strategist wrote. Stocks amounted to 48.6 percent of assets at S&P 500 funds last year, down from 50.5 percent in 2009.
Surging obligations also played a role, according to S&P Dow Jones’s data, published last week. Projected distributions increased 38 percent, to $1.99 trillion, between 2007 and 2012. Assets rose just 2 percent, to $1.53 trillion, as the period began with the worst bear market since the Great Depression." - source Bloomberg

So much for the "Great Rotation" story. Oh well...

"At times it is folly to hasten at other times, to delay. The wise do everything in its proper time." - Ovid

Stay tuned!

Australian Dollar, China and Iron Ore - What's behind the Aussie strength?

"It is in revolutionary periods that the culmination of previous trends and the beginning of new ones appear." - C. L. R. James, Trinidadian journalist. 

While in previous conversations we have discussed the link between China, Iron Ore and the Australian Dollar, we thought a, update was warranted given the continued strength in the Australian dollar.

Recently, China's government tightened housing market restrictions on March 1 in cities with "excessively fast" price gains.

Chinese commodities demand tends to weaken as property development slows. The Australian dollar has historically tracked the country's iron-ore exports to China - source Bloomberg:

The Australian dollar declined massively during the global financial crisis as Chinese demand fell for Australian iron ore. The currency then strengthened as exports of the commodity rebounded, coinciding with China's 4 trillion yuan ($643 billion) fiscal stimulus.


Iron ore is used to make steel, an essential material for housing development. Over the past year, as China has sought to curb housing prices, the Aussie has also tracked the relative performance of property stocks as indicated by Bloomberg.

Since June 2012, the Aussie has tended to move in tandem with the relative performance of the Chinese property sector.

Below you have the comparison between the AUD and the spread between the Shanghai Property Index and the Shanghai index - source Bloomberg:

Property stocks underperformed until March in anticipation of China's implementation of capital gains tax to cool the real estate frenzy. China's announcement of a 20 percent capital gains tax on home sales  on the 1st of March was less stringent than anticipated hence the rebound that followed. The Aussie had also fallen toward par against the U.S. dollar over the same period.

But what has been interesting has been the growing gap between the RBA's monthly commodity price index and the Australian dollar. The Australian dollar has been surprisingly resilient, as indicated by Bloomberg:

"The Reserve Bank of Australia’s decision to cut its key benchmark interest rate to a record low reflects the Australian dollar’s resilience to previous reductions and weaker commodity prices. 

The CHART OF THE DAY shows the RBA’s monthly commodity price index diverging from the local dollar by the most since the beginning of the nation’s China-fueled resource boom a decade ago. It also tracks the overnight cash-rate target that Governor Glenn Stevens and his board reduced to 2.75 percent yesterday, the lowest level since records began in June 1959. The exchange rate “has been little changed at a historically high level over the past 18 months, which is unusual given the decline in export prices and interest rates,” Stevens said in his 6th of May statement.

Stevens has reduced the cash rate by 2 percentage points in the past 19 months, a period when the currency has averaged more than $1.03, compared with 72 U.S. cents in the decade prior. The Aussie was at $1.0197 at 6 p.m. in Sydney yesterday. “It’s a balance between the interest rates being at record lows and the currency being high,” said Greg Gibbs, a Singapore-based senior currency strategist at Royal Bank of Scotland Group Plc. “While the currency remains unresponsive to commodity prices or interest-rate differentials, it increases the potential for rates to go lower.” Commodity prices have tumbled 21 percent from a peak in September 2011, the RBA’s gauge shows. The index “is intended to provide a timely indicator of the prices received by Australian commodity exporters,” according to the central bank’s website." - source Bloomberg

Could the reason behind the continuous resiliency in the Australian dollar due to a rebound in Iron Ore prices?

China imported 67.1 million tonnes of the steelmaking raw material in April, the third highest amount on record and up 4% from March it seems.

And, on Wednesday benchmark CFR import price of 62% iron ore fines at China's Tianjin climbed to $130.20 a tonne, up from its 2013 low of $128.10 reached last week according to Frik Els from Mining.com.

As far as inventories are concerned and as reported by Deutsche Bank in their latest Shipping Weekly from the 6th of May 2013, while inventories improved of their 1st quarter low, they remain below 2010 levels:

- source Deutsche Bank - Shipping Weekly - 6th of May 2013.

We do not think the resiliency of the Australian dollar is due to this rebound, there is, we think more to it and it has to do with two factors.

Factor 1 - Diversification of Central Banks FX Reserves:
The rebalancing of FX reserves as indicated by John Detrixhe in his Bloomberg article from the 3rd of April - Aussie to Loonie Equal Dollar in Attracting Reserves:

"For the first time, central banks are using their reserves to buy about the same amount of currencies from Canada to Australia as they are U.S. dollars in a sign that the pace of diversification is accelerating. Allocations to so-called non-reserve assets rose by $30.1 billion in the last three months of 2012, the most in a year, while those going to the dollar increased by $31.5 billion, according to International Monetary Fund data released on March 29. The $1.4 billion gap is the closest since at least 1999.

The changing makeup of reserve assets reflects the growing clout of second-tier nations as the major developed economies see a shrinking share of worldwide gross domestic product. The U.S., euro region, U.K. and Japan accounted for 52 percent of global GDP product in 2011, down from 69 percent a decade earlier, according to World Bank data. “The new money really got applied to the alternatives, Aussie and Canada, and it’s an ongoing trend,” Greg Anderson, the North America head of Group of 10 currency strategy at New York-based Citigroup Inc., said in a telephone interview. Those currencies have “better credit, higher yield. If you could, you’d probably put your whole portfolio there but they have a scale problem, you can’t do that,” he said.

A category the IMF calls “other currencies,” and which strategists say includes the Australian, New Zealand and Canadian dollars, soared to 6.1 percent of the $6.1 trillion in allocated global reserve assets from 1.8 percent at the end of 2007. The IMF calculates the share based on central-bank data. China, the world’s biggest reserve holder, doesn’t participate.

At the same time, the dollar percentage has shrunk to 61.9 percent from 64.1 percent, and the euro’s share has dwindled to 23.9 percent from 26.3 percent. The IMF said in November that it’s considering classifying the Australia and Canadian dollars as reserve currencies." - source Bloomberg

Factor 2 - Yuan-Aussie Trades:

As indicated in Jason Scott's Bloomberg article from the 11th of April, the Australian dollar cross-currency trading has been given a very big boost by the direct trading between the yuan and the Aussie which reached A$250 million on its first day   - Yuan-Aussie Trades Were A$250 Million on First Day:

"The People’s Bank of China approved Australia & New Zealand Banking Group Ltd. and Westpac Banking Corp. as market makers for the direct trading of the currencies that began yesterday, Gillard said at a press conference in Shanghai on April 8. Asia’s largest economy took about a third of Australia’s exports in February and is its major customer for iron ore and coal. The yuan gained 0.2 percent to 6.5167 per Australian dollar as of 2:32 p.m. in Beijing, according to data compiled by Bloomberg. The Australian dollar follows the greenback and the yen in being able to be directly traded with the yuan. Before the bilateral deal, cross-currency trading between the Aussie and the yuan was about A$20 million a day, according to data compiled by market participants, who asked not to be named." - source Bloomberg.

As far as the Yuan is concerned, you should watch what happens with the Yuan's trading range in the coming months because of the competitive devaluation taking place in Japan  - source Bloomberg:

"China won’t widen the yuan’s trading range for at least four months, as foreign inflows have pushed the currency near the upper end of the 1 percent daily limit, according to Australia & New Zealand Banking Group Ltd. “It would require an easing of capital inflows, or for the market to re-assess People’s Bank of China’s currency management” before the band is altered again, said Khoon Goh, a senior strategist at ANZ in Singapore. The central bank expanded the range from 0.5 percent in April 2012 after a stretch of at least 15 months during which the yuan hovered near the midpoint or tended to weaken. A change now would be an “effective revaluation” as other nations devalue their currencies, he said.
The CHART OF THE DAY shows the onshore yuan gained 3.4 percent against the dollar in the past nine months and has closed stronger than the reference rate since September. The lower panel shows the currency stayed near the maximum 1 percent above the fixing for the last seven months.
Speculation for a change was heightened on April 18 when PBOC Deputy Governor Yi Gang said the band would be widened “in the near future.” Based on the previous adjustment, the central bank probably won’t move “until the yuan is trading closer to the midpoint,” ANZ’s Goh said.
Yuan positions at Chinese financial institutions stemming from foreign-exchange transactions, a gauge of cross-border flows, rose by 1.22 trillion yuan ($197 billion) in the first three months of 2013, more than four times as much as in the same period last year. The inflows helped push the yuan to a 19- year high of 6.1723 per dollar on April 17." - source Bloomberg.

On Thursday the Yuan hit a record high of 6.1336 per dollar in morning Asian trade after the People's Bank of China (PBOC) fixed the yuan mid-point at the highest level since the 2005 revaluation.

What will be interesting to watch in relation to China and as reported by EJ Insight on the 8th of May is as follows:

"New forex position limits could tighten cash flow Starting June 10, banks in China are required to comply with new foreign exchange position limits. The State Administration of Foreign Exchange, the nation’s currency regulator, has linked the position limits to the banks’ foreign currency loan-deposit ratios.

Market analysts estimate the lenders need to buy as much as US$320 billion worth of US dollar to meet the new ratio. This could lead to tighter cash flow in the financial system and higher money rates for a short period. As a result, the central bank may keep a net cash injection via its open market operations.

On the other hand, the new measure, which is aimed at containing the influx of speculative capital, is timely and important at a time when other major economies are exercising monetary easing.

After Australia cut interest rates on Tuesday, South Korea’s central bank is likely to announce a long awaited cut today. According to official data, yuan positions at Chinese financial institutions from foreign exchange transactions rose by 1.22 trillion yuan (US$197 billion) in the first quarter."

And Korea did cut its interest rates by 25 bps. The race to the bottom is on and currency wars are indeed interesting to follow.


"The thing is to be able to outlast the trends." - Paul Anka, Canadian musician.

Stay tuned!

Chart of the Day - Chinese Iron Ore back to 2010 levels

"But it is possible that, in the days ahead, these years we have lived through may eventually be thought of simply as a period of disturbance and regression." - Hjalmar Branting, Swedish statesman 

Back in May 2012, we argued that Australia at some point could be facing the "Iron Ore" conundrum given its exposure to Iron Ore. Although we had it wrong in relation to our negative stance on the Australian dollar, the Australian dollar has been so far remarquably steady compared to the US dollar - source Bloomberg:

When ones look at the significant drop in Iron Ore inventory at port since 2009 coming back to 2010 levels, one can wonder what can be expected in 2013 for Chinese growth given the recent weakness seen in China's PMI - source Deutsche Bank, Shipping Weekly, 4th of March 2013:

While Chinese iron ore imports were up 21% y/y, they were down 4% m/m after a strong December according to Deutsche Bank:

Yet this recent rally can be challenged according to a recent Bloomberg article from the 7th of March - Iron Ore Surge Prompted by Demand, Speculation, China Says:

"A recent surge in iron ore prices was caused by changes in demand, market speculation and “unreasonable” pricing methods, China’s top planning body said. The biggest mining company said it hadn’t curbed supplies.
Chinese steelmakers re-stocked iron ore during the traditional “winter reserve” period and ramped up purchases as confidence in the economy improved, leading to an explosive increase in demand in the short term, the National Development and Reform Commission said in a statement on its website.

Chinese steelmakers re-stocked iron ore during the traditional “winter reserve” period and ramped up purchases as confidence in the economy improved, leading to an explosive increase in demand in the short term, the National Development and Reform Commission said in a statement on its website.
The three largest mining companies and certain traders either delayed or controlled deliveries to make up for their previous losses, creating a false impression of temporary short supply, according to the NDRC. Some mining companies also bought iron ore from the market to drive up prices, it said. - source Bloomberg

Iron ore exports to China from Australia are indeed a strong indicator of Chinese industrial activity, and given it fell by 14.8% in February from 18.38 million tonnes in January to 15.66 million tonnes in February, one can wonder if the Chinese holiday season or the cyclone disruptions are entirely responsible for the slowdown or if there is more to it given Korea data could indeed herald surprise China exports drop according to Bloomberg:

"South Korea’s biggest export drop in seven months suggests China will surprise the market and also report fewer shipments in February, lessening the case for monetary tightening in the world’s second-biggest economy, according to Nomura Holdings Inc. 
South Korea is the only one of Asia’s 10 biggest economies to report February trade data thus far. Given that China is its biggest export market, Korea’s sales drop signals that its larger neighbor is poised to report weaker-than-expected shipments, said Zhang Zhiwei, Nomura’s chief China economist. The CHART OF THE DAY tracks monthly changes in the two nations’ overseas sales since 2008. South Korea said exports in February declined 8.6 percent from a year earlier, the second drop in three months. Based on that result, Zhang predicts China will announce tomorrow a 10 percent decrease when February figures are released in Beijing. Nomura’s economist is among only six of 33 analysts surveyed by Bloomberg that predict a drop. The median estimate is for an 8.1 percent increase. “The data suggests China’s recovery is not so strong,” Hong Kong-based Zhang said. “We still call for the People’s Bank of China to tighten policies, hike interest rates and regulate shadow banking activities this year. But recent weak macro data will only make the central bank delay it.” 
China this week affirmed its 2013 growth target at 7.5 percent after the economy grew 7.8 percent in 2012, the slowest pace in 13 years. China will report a February trade deficit of $28.5 billion, according to Zhang. That would be the first shortfall in a year and compares with an average monthly surplus of $16 billion in the past three years. Growth rates for exports and imports in the first two months are distorted by changes in the timing of the weeklong Chinese New Year holiday, which fell in February this year and January in 2012. Nomura’s forecasts tie in with the new export orders component of China’s official Purchasing Managers’ Index, reported on March 1, which fell to a six-month low of 47.3 in February. The broader PMI sank to a five-month low of 50.1, according to data from the National Bureau of Statistics and China Federation of Logistics and Purchasing. A reading of 50 marks the divide between expansion and contraction." - source Bloomberg.

Could the recent slowdown and price manipulations for Iron Ore spell trouble as well for neighbor Australia given its dependency to Iron Ore exports? We wonder.

One thing for sure, the recent weakness in Korea's exports courtesy of Japan's agressive monetary stance has put the Japan-Korean risk gap near parity has indicated by Bloomberg:

"The push by Japan, the world’s most-indebted government, to weaken its currency to boost exports and end deflation may reduce its perceived default risk below South Korea’s, where won gains are having the reverse effect. The CHART OF THE DAY tracks the cost of insuring the five- year sovereign bonds of Japan and South Korea since August. Thespread between the two credit-default swaps fell to 1.2 basis points on Feb. 5, the narrowest since Oct. 11, the last time it was more expensive to insure against a Korean default, data compiled by CMA show." - source Bloomberg

Korea losing its competitive edge towards Japan thanks to a weakening Japanese yen could indicate weaker than expected Chinese growth as well as impacting Australia in the process.

"Worry is interest paid on trouble before it comes due." - William Ralph Inge, English clergyman



Stay tuned!

Australia and the Iron Ore conundrum

"The most fatal illusion is the narrow point of view. Since life is growth and motion, a fixed point of view kills anybody who has one."
Brooks Atkinson

Following up on our recent Shipping conversations ("Shipping is a leading credit indicator - A follow up"; "Shipping is a leading deflationary indicator"), we thought we would venture towards "Down Under", namely Australia given the recent weakness of Chinese Iron-Ore Inventory which have been declining for four weeks and are now below 2011 highs represent a serious conundrum for Australia's economic growth in general and AUD-USD in particular.

Source Deutsche Bank Shipping Weekly - 21st of May 2012

In fact since the beginning of the year both the Brazilian Real as well as the Australian Dollar have experienced a significant weakness versus the US Dollar - source Bloomberg.

While both commodities depending currencies had moved in synch versus the US dollar, the correlation between both broke last year leading to significant divergence between both currencies.

In a recent note entitled "Iron Ore Summer Slowdown" published by Deutsche Bank, their analysts indicated the following:

"Iron ore exports from Brazil have disappointed. Export levels have been poor due to various factors including adverse weather and infrastructure challenges. We expect that export levels are likely to exceed 25mt/month over the next couple of quarters. This normalisation of Brazilian exports could put additional pressure on the market as well.

Certainly we would expect that both Brazilian and Australian producers will be sensitive to the demand requirements of their customers, Europe and China principally, who we expect will be under considerable pressure over the summer slowdown period. On this basis one would expect that exports may drift lower in response to this. Nevertheless we believe that the ability of the key suppliers to ship tonnage to market will improve over this time-frame."

As Dylan Grice put it in his note "Australians be worried: someone is calling your country a miracle!" from the 25th of April:

"Australia's two biggest commodity exports are iron ore and coal. According to the RBA Australia has increased its iron ore capacity by 150Mtpa in the last five years, from 300Mtpa to 450Mpta. Planned capacity increases over the next five years amount to a further 200Mtpa (see chart below). Nearly all of it will go to China to feed the burgeoning steel industry there. But how healthy is China's iron ore demand? If its steel prospects were so attractive why does Wuhan Iron and Steel for one think pigs are the future? Why has the company recently announced plans to invest nearly $5bn over the next five years in industries in which it has no expertise, such as pig, fish and organic vegetable farming? Probably because steelmakers are now loss making and there is excess capacity. And if they have no confidence in the Chinese steel industry, why should Australia?"

In fact Deutsche Bank analysts in their note "Iron Ore Summer Slowdown" remain cautious near term:

"DB steel analysts in China are cautious near-term. After average daily production volumes reached 2.03mt/day in April, utilisation rates are now starting to moderate as end-use demand fails to materialise. In fact we understand that fabricators have high levels of finished inventories. Furthermore, steel inventories while falling are being drawn down at a slower rate than is usual for this time of year."

China growth cooling and implications for Iron Ore:

"Our China steel team expects that Chinese steel production growth will average nearly 4% YoY in 2012(reaching 710mt), as compared to 7.3% growth last year. Utilisation rates are forecast to fall to 86% in 2012.

However we anticipate that these figures may be downgraded if in fact a Chinese economic recovery is delayed or if GDP growth is lower than anticipated. We have concerns about the weakness of the three major fixed asset investment (FAI) pillars (infrastructure, real estate and manufacturing). As our team has indicated previously, excessive manufacturing growth in 2011(which was the highest since 2006) is worrying as it potentially sets the stage for a capex down-cycle for the sector in 2012. Of note, the aggregate capex for Chinese companies under DB analyst coverage is projected to decline in 2012." - source Deutsche Bank.

As indicated by Reuters on the 24th of May:

"Spot iron ore prices have fallen to a 6-1/2 month low below $130 a tonne this week, as steel mills in top consumer China deferred shipments and curbed fresh buying after domestic steel prices hovered near their cheapest in half a year.

Plummeting steel prices, which have shed 6 percent in May, coupled with doubts about domestic demand, are keeping China's army of steelmakers on edge, making them reluctant to commit to new orders.

With growing uncertainty over whether iron ore prices will continue to drop, Chinese steel mills have been picking up material they do need from ore piled at ports rather than making forward bookings with miners, which can take at least 20 days to arrive from Australia."

From the same article:
"If prices were to hit $120 a tonne, it could lead to the closure of some high-cost Chinese miners."

Source Deutsche Bank - "Iron Ore Summer Slowdown" - 17th of May 2012

It's still a game of survival of the fittest in this deflationary environment...

And as Dylan Grice put it in his note focusing on Australia:

"If Chinese resource demand holds up everything will probably be fine. But if it doesn't, well, everything won't be. In fact, there might be trouble anyway. The improvement in Australia's terms of trade (the ratio of its export prices to its import prices) has been spectacular thanks to the bull run in commodities. It should be running large current account surpluses, like Norway. But it isn't. It's running a deficit of 3%. So the AUD is overvalued and vulnerable."

Hence our negative view on Australian Dollar.

"All truth, in the long run, is only common sense clarified."
Thomas Huxley

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