What Rising Iron Ore Prices Mean for Interest Rates

Stocks on Wall Street took a breather overnight, but the price of iron ore continued to move higher. Iron ore for delivery to the Chinese port of Qingdao is now trading at US$80.83 per tonne. According to the Financial Review, that’s a 26% surge this month.

While momentum may push prices higher in the short term, any price rise of this magnitude, in such a short space of time, needs to be treated with caution. Translated: Watch out for a correction.

Iron ore is Australia’s most valuable export. Higher prices, combined with a big rise in volumes over the past few years, provide a big boost to Australia’s ‘national income’.

That is, higher iron ore prices are a type of pay rise for the Australian economy. Not that anyone seems to be seeing it right now, given wages growth is at a multi-decade low.

But that’s because we’re still working off the massive pay rise from the previous resources boom. So it’s probably a little too much to expect another increase so soon!

Still, it takes a while for rising iron ore prices to filter through to the economy. Next week sees the national accounts (economic growth data) out for the three months to September. You’ll likely see a decent increase in the terms of trade, which will provide a boost to Australia’s national income.

National income is a better measure of Australia’s economic well-being than the traditional GDP measure. That’s because it takes into account the prices that we receive for our exports (like iron ore), as well as the prices we pay for the things we import. The headline economic number you see in the media ignores prices received and paid, and only focuses on how much the economy produces.

If iron ore prices stay high, you’ll see an even bigger increase in the terms of trade and national income in the current (December) quarter, when that data comes out early next year.

But that’s the question, isn’t it?

Will prices stay high?

It’s an important question, because the outcome has big ramifications for the Aussie economy.

Consider that the last iron ore boom, from 2009 to 2011, had such a big impact on national income growth that the RBA had to raise interest rates from a low of 3% in September 2009, to 4.75% in November 2010.

That’s 175 basis points of interest rate increases in 13 months!

The reason why the economy could handle such interest rates rises was because they were offset by the income flowing in from the China-led, post-GFC mining boom.

Low interest rates, plus a commodity boom, are a recipe for inflation. That’s why the RBA increased interest rates during that time. It’s also why the housing market was weak during that period.

Now, official interest rates are half the level of what they were in 2009. They’re sitting at an emergency-like 1.5%, and iron ore and other commodities are rising again.

Does this mean you should get ready for another tightening cycle?

Do you think the household sector or the economy could handle interest rates doubling from here?

I’m not so sure.

Firstly, households are much more indebted now than they were in 2009. You can see this on the left-hand side of the chart below.


Source: RBA Chart Pack
[Click to open in new window]

Debt as a percentage of household disposable income is at record highs. The interest paid on that debt (right-hand side of chart) is low, thanks to record low interest rates.

But that could rise sharply if interest rates rise, as households are now much more sensitive to interest rate increases.

The RBA knows this, and will be much more reticent to raise rates as fast as they did during the last cycle.

Also, there are fewer growth drivers in the economy. During the last commodity boom, the price rises brought out a huge increase in investment. This investment predominantly occurred in the iron ore and oil and gas sectors.

That’s the reason why the RBA increased rates. It was an attempt to divert Australia’s economic resources to satisfy the resource investment boom.

But, this time around, you’re not going to get a big increase in investment. You might see an uptick across the base metals, but we’re talking about a pretty small increase. The major work has been done for years to come.

Rising interest rates from here would exacerbate the looming slowdown in housing and apartment construction, which has taken the growth baton from the resource sector over the past few years.

That would weaken investment across the economy and affect household consumption, which is the largest driver of economic growth.

Finally, you have to wonder (I do, anyway) just how sustainable this China-led iron ore boom is. Over the past few years, China has put its foot on the pedal and taken it off again in order to manage its economy. Each of these episodes has a major impact on the iron ore price.

My guess is that we’re closer to seeing China take the foot off the pedal than apply pressure. That means you should see the iron ore price head lower soon.

If that happens, it will take the pressure off the RBA too. But with the US Federal Reserve set to raise interest rates in the next few weeks, it will serve as a reminder that the global interest rate easing cycle may well be over.

Regards,

Greg Canavan,
For Markets and Money

Editor’s Note: Newman Show Hijacked! James Woodburn and Kris Sayce hijacked The Newman Show to discuss recent market news across Money Morning and Markets and Money.

Join Woody and Sayce for an informal discussion on…Trump infrastructure spending… where the money’s going…resource investment opportunities…how far the Aussie housing market has left to run…the war on cash… You can watch all that, and more, right here.


Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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