Grim reading for the public purse

We continue to beat the table that our thematics and investment choices are the right ones and trade overnight continues to reinforce this.

Source: Bloomberg

As a result, traders will be looking to be:

- Short commodities

- Long industrials from Europe or Japan

- Still positive on the yield trade (albeit with one foot out the door as it will unwind quickly when it goes)

- USD earners

The thematics underlying this are:

- USD strength due to central bank differentials

- Bond yields remain at record lows due to the record low cash rate environment

- Central bank taps will remain open and freely flowing

- Global inflation remains at the bottom of central government expectations and disinflation remains a real concern

- Growth remains elusive across the world

- Commodity prices remain locked in bear markets

The last point of the underlying thematics makes very grim reading for those working and/or involved in the commodity sphere.

Market and media talk around the iron ore price will be deafening over the coming weeks as its falls to levels not seen since records began. There is a very strong argument to be made that prices will overshoot - I see low US$40 a tonne handles as a near-certainty in the coming weeks and this will create mass worry in a market looking for reasons to sell.

Currently, the supply-demand equilibrium is being smashed – Australia and Brazil are pumping millions of tonnes into the supply side to maintain cash flow as the cost of margin. This issue, however, is that expectations would have been for some sort of demand pick up as price fell to support levels of the previous years – so far China has remained silent and only purchases what is needed. There will come a point where prices will be so cheap China will be unable to resist stockpiling – unfortunately we are not there yet.

The collapse in the iron ore price is going to (in fact already has had) a devastating impact on the public purse. The revenue collapse from the cash cow that was iron ore royalties will be felt most in WA. But the Federal Government now has a hole in its estimates that it can’t fill through current tax streams. This ‘should’ cause the government to act and when it does, confidence will be hit again as taxes rise as it looks to fill the gap (Super looks like being the biggest target for tax changes).

Another thing which suggests to me that the hole may never be filled again is the news the WA government has deferred 50% of BC Iron’s royalty payment - this will have plenty more running to the treasury department asking for the same treatment. It also means junior materials plays are well and truly on their knees and are at breaking points - most are well and truly under water on a per tonne basis and will have to close doors sooner or later.

There is a perpetual catch to this current scenario developing in iron ore - falling iron ore prices are sending AUD/USD down tick for tick. The correlation is near 100% - why? As the iron ore price collapse builds, expectations of further rate cuts and even other forms of monetary stimulus ramp up.

The interbank market is now pricing in a 70% expectation of a 25 basis point cut at next Tuesday meeting. However, only seven of the 27 economist surveyed by Bloomberg expect the RBA to move. At the February meeting the interbank market was at the same price level, economist calls were at similar levels to what they are now - draw your own conclusions from this.

This is why the yield trade is almost self-fulfilling. The comparison of the Australian three-year bond overlaid with the ASX-financial sectors clearly tells you that rate cuts expectations are building as the bond is being bid-up at all cost and yields in the three-year is plummeting. 

This is why I am still positive on the yield trade (for now) – resistant the contrarian call - the yield trade in Australian equities is not done with yet. The market is going to get volatile and confidence will be hit as iron ore and bulk commodities in general side leg lower into a bear market – capital growth will be minimal but more likely to be maintained than the declining cyclical names.

Ahead of the Australian open

Further negative sentiment in the US coupled with the iron ore price at US$49.53 a tonne would normally see Aussie futures in the red. However as this is the last trading day before the next RBA meeting and the market’s expectations is for another rate – expect upside positioning. We are calling the market up 20 points to 5880 and I expect the banks to benefit from solid buying.



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